5 Points to Consider Before Prepaying Your Personal Loan
Many personal loan borrowers seek to prepay their loans either fully or partially to reduce their interest costs. However, prepaying a personal loan may not always be the optimal option. Here are some important aspects of personal loan prepayment that existing borrowers should consider before selecting this option:
Table of Contents
Check Prepayment or Foreclosure Fees
The RBI has restricted banks from charging part-prepayment or foreclosure fees on floating rate personal loans. However, these restrictions are not applicable on personal loans availed at fixed interest rates. Therefore, lenders usually levy prepayment fees of up to 5% of the outstanding principal amount on fixed interest rate personal loans. Many lenders allow their personal loan borrowers to part-prepay or foreclose their loans only after the repayment of a predetermined number of EMIs. Prospective applicants can check the part-prepayment or foreclosure charges on lender websites. They can also visit online financial marketplaces like Paisabazaar to compare the prepayment fees charged by multiple personal loan lenders.
Calculate the net interest cost savings
Many prospective loan applicants incorrectly assume that only prepayments made during the initial years of the loan tenure lead to higher interest cost savings. However, they can also make savings in interest costs by prepaying their loan in the later years of their loan tenure. Hence, existing borrowers having adequate surpluses to prepay their loans should use the online personal loan prepayment calculators to determine the net savings from making prepayments after factoring in the penalties and related costs (if any). They should choose to part-prepay or foreclosure only if they make significant interest cost savings, after factoring in the total expenses incurred in this process.
Should you prepay or invest
Personal loan borrowers having surplus funds can use it to either invest in financial instruments or prepay their loans. However, their decision should be made after comparing the savings made from prepayment vis a vis prospective returns from the investment made. For example, investing the surplus amount in equity mutual funds during the bearish market phase may lead to higher benefits as the valuation of these financial instruments are attractive in these market phases. Therefore, the upside potential of opting for equity investments during bearish markets may be significantly higher than any interest cost savings made through personal loan prepayments.
Avoid prepaying your loan using emergency funds
Having an emergency fund helps you deal with financial contingencies like medical emergencies, job/income loss, disability, etc. Ideally, your emergency corpus should cover a minimum 6 months of your unavoidable monthly expenses like loan EMIs, utility bills, insurance premiums, etc. However, some personal loan borrowers may prepay their loans using emergency funds to reduce their interest costs. Although they may generate considerable interest cost savings, any financial emergencies arising after prepaying their loans may force them to redeem their long-term investments or opt for high interest rate loans to arrange the funds.
Avoid redeeming high return yielding investments
Many personal loan borrowers redeem their fixed deposits, mutual funds, insurance policies or other ongoing investments for loan prepayment without doing a proper cost-benefit analysis. They should avoid liquidating investments that have the potential to generate higher returns than the interest rates of their existing loans. Existing borrowers seeking to prepay their personal loans should only use those investments not linked to their crucial financial goals or yielding lower returns than their personal loan interest rates.
Conclusion
Prepaying your personal loans help reduce your interest costs and repayment obligations. However, borrowers should consider the prepayment charges, if any, and decreased liquidity before deciding to prepay their personal loans. Those having low or restricted liquidity can consider transferring their outstanding personal loans to banks/NBFCs offering lower interest rates. Therefore, exercising the personal loan balance transfer option at lower interest rates would help reduce their overall interest costs and EMI burden while retaining their liquidity.
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