Personal loan is a popular financial product used for innumerable purposes such as consolidating debt, financing a medical emergency or fulfilling long-held-up needs such as overseas traveling. When comparing different personal loan offers, many people consider interest rate as the sole deciding factor. However, there are other rates and charges as well (such as pre-payment charges) that must not be ignored.
Loan helps in easing financial stress. However, for many, the interest amount starts straining their monthly budgets and affecting other financial goals. Hence, more often than not, borrowers wish to prepay their loans whenever their finances allow them to do so. To get peace of mind, personal loan prepayment might be the right thing to do. However, is it financially beneficial?
Before getting into the details of personal loan prepayment, let’s understand what it is.
What is prepayment?
As the name suggests, prepayment is when borrowers repay the loan amount to their lenders in advance. The prepayment can be made in parts or full. Usually banks allow personal loan borrowers to pay at least 12 EMIs of the loan before prepaying the outstanding loan amount.
What are the pre-payment charges?
Since prepaying a loan would mean less interest amount for banks, therefore, they levy pre-payment charges over it. Most financial institutions levy pre-payment charges from 1% to 5% of the principal outstanding. While most banks levy flat pre-payment charges, there are a few banks that may levy pre-payment charges at different rates depending in which year of your loan tenure does the borrower wishes to prepay. For instance, the ICICI Bank levies pre-payment charges at a flat rate of 5% per annum of principal outstanding. On the other hand, the HDFC Bank charges 4% per annum of principal outstanding in the second year of the loan tenure, 3% per annum of principal outstanding in the third year of the loan tenure and 2% per annum of principal outstanding in the remaining time of the loan tenure.
Pre-payment charges of some popular banks
|HDFC Bank||13-24 months – 4% of principal outstanding |
25-36 months – 3% of principal outstanding
>36 months – 2% of principal outstanding
|ICICI Bank||5% p.a. of principal outstanding|
|YES Bank||13-24 months – 4% of EMI repayment |
25-36 months – 3 % of EMI repayment
37-48 months – 2% of EMI repayment
>48 months – Nil
|Kotak Mahindra Bank||Up to 4% on total principal outstanding at the time of calculating the amount for full and final settlement of account; plus, interest for the ongoing month.|
Is prepaying your personal loan beneficial?
If you choose to prepay your personal loan, there are two ways to do it. Either you pay the loan amount partially or fully. Let’s consider each case on a hypothetical situation and look whether the result turns out to be beneficial or not.
Situation: Let’s suppose that you have taken a personal loan of Rs. 5 lakhs for 4 years at a rate of 15% per annum. The loan EMI payable will be Rs. 13,915. The total interest to be paid by you during the loan term will be Rs. 1,67,938. Also, the loan has a lock-in period of one year, which means you cannot prepay before a year.
Scenario 1: Full Pre-payment
Banks usually have a lock-in period of one year on personal loan. This is because a better part of the interest amount is charged in the initial period of the loan tenure. With the help of the given situation, let’s understand this further:
The following table depicts the interest amount that was paid each year.
|No. of Years||Principal Amount||Interest Amount||Percentage of Total Interest Cost||Interest Saving|
|1||Rs. 98,579||Rs. 68,405||40.73%||Lock-in Period|
|2||Rs. 1,14,427||Rs. 52,558||31.30%||Rs. 99,533 (59.27%)|
|3||Rs. 1,32,821||Rs. 34,163||20.34%||Rs. 46,975 (27.97%)|
|4||Rs. 1,54,173||Rs. 12,812||7.63%||Rs. 12,812 (7.63%)|
Explanation: In the first year (lock-in period), the interest payable will be Rs. 68,405, which is about more than 60% of total interest cost. From the second year onwards, the interest amount starts depreciating provided the EMIs are paid on time. From the table given above, it is clear that repaying your loan sooner will help you save on your interest amount. If you pay in the starting month of the second year, you can save about 60% of the interest amount. Every money costs, therefore, even if you decide to prepay your loan in the later years of the loan tenure, you will be able to save a significant amount of interest. Besides interest amount, another factor borrowers must consider is the pre-payment charges.
Scenario 2: Part Pre-payment
Part prepayment is when you repay a part of the outstanding balance to your lender in advance. Some banks allow their borrowers to partly prepay their personal loans and some don’t. For instance, ICICI Bank does not offer part pre-payment facility. However, HDFC Bank does allow for this facility. The rates for part pre-payment facility vary from one lender to another, therefore, one must consider for this facility and related charges before availing personal loan.
It is not necessary that you can save on the interest amount only through full prepayment. If you do not have sufficient money to prepay the outstanding amount in full, you can consider part pre-payment option. Whatever amount you decide to pay will get deducted from whatever total outstanding amount you have on the loan, thus, saving a considerable interest amount when the principal amount reduces. Let’s take the same example. If you pay off Rs. 1,50,000 immediately after the lock-in period gets completed, you can save on the interest amount considerably. Let’s understand this better:
Explanation: As per the table given above, you have paid Rs. 98,579 in the first year of the loan tenure, which is also the lock-in period. So this leaves us with Rs. 4,01,421 (remaining principal amount). Now immediately after the lock-in period ends, if you part prepay an amount of Rs. 1,50,000, the outstanding balance will further drop to Rs. 2,51,421. This implies that in the second year, your lender will now calculate interest on this new outstanding principle amount.
If your finances allow, you can pre pay more than once in your loan tenure. However, many banks and NBFCs restrict on the number of times borrowers can part prepay the loan amount. Therefore, borrowers must check all the rates, charges and related clauses concerning loan before signing the dotted line.
Pre-paying personal loan fully or partially can be advantageous if done during the early phase of the loan or soon after the lock-in period ends. If your lender levies pre-payment (full or partial) charges, compare the amount you will save with the pre-payment cost that you will have to pay to your lender. If you save a good amount of money, go ahead with pre-payment option else don’t.
(With inputs from Paisabazaar.com)