- Personal Finance
Learn More About: Loan Pre-Payment Penalty
Loan prepayment is an offer extended by most lenders, usually banks, to pay off a loan before the stipulated date. Outstanding loan amounts can be pre-paid either partially or entirely. This facility is usually extended to borrowers after a specified amount of time has lapsed since the first installment is paid. Prepayments enable borrowers to save money by reducing or ending the burden of a loan.
It might sound very economical, paying off your loans earlier than planned. But most banks discourage pre-payments by levying penalties for early closure of loans. These are known as prepayment penalties. Early repayment of loans is financially unviable for banks as it leads to lower interest income than expected. In fact, in cases such as mortgage refinancing, banks can potentially lose sizable amounts if pre-closure charges are not applied.
Interest is calculated on the principal outstanding. Prepayments go toward reducing the principal outstanding. To compensate for this loss of interest income, banks apply a penalty which is generally charged as a percentage of the overall outstanding loan balance, or as the interest value for a certain number of months.
Prepayment penalties are generally charged at 2% - 5% of the overall loan amount or on a reducing balance basis as specified by the lender.
Depending on your lender, prepayments can attract – no penalties, partial-waiver of penalties or penalties at a pre-determined rate.
- If a lender doesn’t charge a prepayment penalty, you can pay off your loan comfortably and reduce your debt burden.
- If partial waivers are allowed, your lender might let you make prepayments without a penalty but will cap prepayment amounts. For e.g. If you can prepay 50% of the loan outstanding, your lender will allow a prepayment of 25% without a penalty but charge a penalty on the remaining 25%. Even with partial waivers, borrowers can save on interest payments.
- A prepayment penalty is applied by many banks on all loan pre-closures irrespective of the amount or maturity date. This should be a point of consideration when choosing a loan scheme. If you envision closing or refinancing your loan, it is advisable to opt for a loan scheme that does not feature a prepayment penalty.
To prepay or not to prepay?
It really depends on the borrower in question. Most people prepay loans based on an increase in income or to refinance an existing loan, in order to make debt more affordable or manage it better.
If you have the money to foreclose your loan, consider whether prepaying your loan is the best use of those funds. While getting out of debt is advisable, consider other financial obligations as well.
- Do you have any major expenses round the corner e.g. marriage, college fees, etc?
- Are you in a sound position to avail more credit if the need arises?
- Do the positives of being debt-free outweigh the tax benefits from your loan?
- Can you redirect surplus funds to more profitable investment avenues?
- How is your credit score affected by prepaying your loan?
- Are new interest rates substantially lower to justify refinancing a loan?
Do the math
Low prepayment penalties or the absence of such charges does not solely justify early repayment. You have to make a calculated decision based on facts and figures. Consider the actual penalty amount, loss of tax benefits, interest saved, loan processing charges and new EMI figures (if prepaying with the intention of refinancing). Also consider the buffer/lock-in period i.e. where prepayment is not possible.
Here are some simple ways to quantitatively ascertain your prepayment benefits.
Prepayment benefits from using surplus funds = Total interest saved – (foreclosure charges + tax benefits lost + potential returns*)
*Potential returns refers to the returns you might have earned from investing the prepayment amount in alternative instruments e.g. debt or equity .
Prepayment benefits from refinancing = Old EMI – (foreclosure charges + new loan processing charges + new EMI figure)
Alternatively, you can use EMI calculators which are financial tools available online. By inputting loan details and prepayment amounts, these calculators help you find the most optimal prepayment solutions by indicating the amount you save or lose by prepaying. They are freely available online, either at your bank’s website or at those of online financial services providers. A simple google search will lead you to one that is easy to use. Along with changes to EMIs payable, some calculators also provide a complete repayment schedule indicating how much you’ve saved or lost by making a prepayment. They also show whether a prepayment penalty is a viable financial decision or not by providing accurate figures on your chosen loan scheme.
Making it work
The trick here is to understand the underlying gains and losses, not easily ascertained without a careful reading of the terms of the loan agreement. The onus lies on you as a borrower to decide whether paying a penalty is worth your while based on your personal financial situation and goals. Consider all angles carefully to make informed choices to mitigate the risks involved.
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