Prepayment or Loans: To Do or Not to Do?

We often end up taking loans for many a reason, like educational loan, auto loan, home loan, gold loan, personal loan, etc. and then sometimes suffer when it comes to repaying. There may be certain times when we have enough amount and we plan for a prepayment of loan. Yes, prepayment, as by the word, means repaying the lender with the loan amount ahead of the stipulated tenure. It therefore involves paying off an extra amount towards the EMI which in turn reduces the overall tenure, total interest and hence the reduction in the entire amount paid. Also, because of the above stated three reasons, banks tend to charge a penalty on such kinds of transaction where the borrower prepays for an early closure.

Let us therefore discuss the pros and cons to the prepayment of loans.

And starting off with the good things first. The Pros:

1. Some banks like the SBI (State Bank of India) have no penalty charged for prepayment of prepaid loans once it has ensured that own funds are used for the payments.
2. Due to the recent RBI (Reserve Bank of India) announcement, banks are prohibited from charging penalty against prepayment of home loans.
3. A major benefit is that the prepayment can be linked in order to avail rebate on tax under Section 80C.
4. Reduction in overall tenure and total interest paid is another benefit.

Yes, every rose has its thorn! And hence, the Cons:

1. Banks ensure they charge a penalty when the borrower seeks to prepay for an early closure. This is because banks earn when the tenure of the repayment is large because in that case the interest earned is also higher, and when the borrower tends to diminish the tenure by prepaying the amount, banks would otherwise run on loss or with negligible profitability. Hence the banks charge penalty almost up to 3% on the balance amount.
2. The penalties vary from one institution to another and even varies based on loan. The penalties charged are either at flat rates or even certain period of months’ interest.

Make sure you do not prepay when you have only a few years of tenure left because in such case it is rather preferable and advisable to invest elsewhere rather than prepaying.

Loan owners remain under the impression that since they already have paid a substantial number and amount of EMIs, and lower is the interest component which in turn makes no sense to prepay the outstanding loan amount. However, the reality is that the borrower actually pays the same interest amount for the not yet paid principal amount. This is because the interest is calculated using a method called the reducing balance method. Borrowers should hence measure and consider before prepayment, the current interest rate and not the loan tenure.

Whether to prepay or not to prepay the loan amount hence depends on many factors, for example, the loan payment stage the borrower is at, the rate of interest, the penalty charges and the prepayment charges. A thorough analysis of all these elements should be a must to-do item before deciding on taking any action towards prepayment. In case you have extra cash, use that surplus money to make prepayment keeping note of the above stated major points and then decide on prepayment or other investment options available in the market.