Pros and cons of early closure of personal loans

Ranjit Punja

A personal loan is a valuable option when you are in urgent need of money for a relatively short term. While the interest rates might be relatively high (because the loan is not secured by any collateral), there are no restrictions on its end-use. Unlike a housing loan or auto loan which can be used only to buy property and a vehicle respectively, there is no constraint on how you can use the money in a personal loan. As a result, the documentation required is also simpler.

Personal loans are some of the most expensive loans in the market with interest rates generally between 15% and 20%.  Sometimes, it might be possible for you to pay your loan off in advance rather than waiting till the end of the loan tenure to fully pay it off. Any prepayment means a substantial savings in terms of interest costs since the rates are so high.

Is pre-paying your loan a good idea

To prepay or not to prepay — that is the question. Prepayment is when a borrower pays off his/her loan entirely or in part before the due date. Indians are traditionally averse to taking on debt – though that mindset is rapidly changing now. Having taken a loan, many are anxious to pay it off as quickly as possible, if their finances allow it. However, while prepaying a loan may offer mental peace of mind, it might not always be the most financially advisable option.

There are two factors you need to keep in mind when deciding whether to foreclose your personal loan:

Penalties

Most banks levy a penalty charge when you pay off your loan earlier than the due date. This prepayment penalty fee varies with each bank.

It can be a flat fee or it could be calculated on the basis of the remaining interest due. So it is very important to calculate what your penalty fee will be and compare it to the savings you will earn in terms of continuing to pay interest charges on your loan for the remainder of the tenure. Some banks do not charge any fee for prepaying a loan. Banks do not charge a foreclosure penalty on ‘floating rate’ loans either – however, since most personal loans are on a fixed rate basis, this rule does not apply.

Also remember that there is usually a minimum lock-in period (typically one year) during which you cannot pay off your loan. It is only after this period is over that you can consider the benefits and downsides to foreclosing your personal loan.

Calculate how much you will pay in terms of the foreclosure fee and how much you will save in remaining interest charges when you pay off your loan. If need be, talk to your lender to get an accurate idea of what your repayment burden will be if you choose to foreclose, together with the other terms and conditions on your loan.

Savings on principal amount

Ideally, prepaying your loan early into your tenure saves you the most money. However, for most, it might be possible to do so only later on in the loan period. Many borrowers who have already paid a large number of EMIs think that the interest on the remaining EMIs will be low and therefore it does not make sense to close the loan since they will not be saving much in terms of remaining interest costs. However, keep in mind that the interest paid on the unpaid principal amount is the same since banks calculate interest based on the reducing balance method. In this case, you need to take into account the interest rate charged, rather than deciding only on the basis of the remaining loan tenure, when contemplating whether to foreclose your loan.

Alternatively, you can also choose to make a part pre-payment – or paying off only part of your loan. This reduces the unpaid principal amount, thereby reducing the interest component of your EMIs. However, this option makes sense only if you pay off a substantial amount of your loan amount, and you do it relatively early on in the tenure of the loan – otherwise, the pre-payment penalty might be larger than the interest savings.

While trying to pay off your debts is a good move, it is not always financially advantageous. Make sure that you do the calculation when prepaying your loan. Read the terms and conditions of your loan agreement carefully and talk to your lender if you are in any doubt of what you are liable to pay. The remaining loan tenure, the interest rate and the penalty fee are the factors that you need to consider before making a final decision.

The writer is CEO & co-founder, CreditMantri. The views expressed in this article are his own