Personal loan is a popular loan option among masses due to unsecured nature, quicker disbursals and no end use restriction. However, due to its higher interest rate, borrowers try to prepay them whenever they have surplus funds. Individuals considering to partly prepaying or foreclosing their personal loans should have these important points always in their minds:
1-Take Prepayment/Foreclosure Charges into Consideration
The Reserve Bank of India (RBI) has barred banks and NBFCs from levying prepayment or foreclosure charges on floating rate retail loans. Therefore, floating rate personal loans do not attract any prepayment/ foreclosure charges. However, personal loans availed at fixed rate of interest may incur these charges, which may go up to 5% of the principal outstanding.
Another important point to remember is that many personal loan lenders do not allow part or full prepayment until the borrower repays a predetermined number of loan EMIs.
2-Determine Net Savings on the Interest Cost
The first and foremost purpose of prepaying a loan is to save on the interest cost. Many people believe that they can save on their loan’s interest cost only if they make prepayments in the initial years of the loan tenure. However, prepaying personal loan in the later years also lead to savings on the loan’s EMI payments. To calculate net savings on prepaying/ foreclosing personal loans, borrowers should use an online personal loan prepayment calculator. When determining the net savings on personal loan prepayment, borrowers should remember to consider prepayment/foreclosure charges and other costs (if any). Borrowers should go for prepayment only when they are able to make considerable savings after factoring in other costs related to the process.
3-Do Not Compromise on Your Emergency Funds
The COVID-19 pandemic has made us realise the importance of building/ maintaining an emergency fund. Everyone should build or maintain one as these funds provide people with a financial fall back when they are hit with an unforeseen financial contingency such as disability, loss of income, job loss, etc. An emergency fund, ideally, should be big enough to accommodate at least 6 months’ of one’s monthly mandatory expenses like their home rent, utility bill, children’s tuition fee, insurance premiums, loan EMIs, etc.However, some people forsake it for prepaying their personal loans. By doing so, they may save on their loan’s overall interest cost; but will considerably hamper their financial health. In case of any financial exigency, lack of sufficient emergency funds will force them to either redeem their long-term investments or avail loans at a higher interest rate.
4- Avoid Redeeming Investments that Yield High Returns
Many borrowers want to get rid of their loan obligations as soon as possible and in an effort to do so they redeem their investments such as fixed deposits, mutual funds, insurance policies, etc. without doing the cost benefit analysis. Even if borrowers need to redeem their investments, they should liquidate them after considering their potential returns. They should avoid liquidating investments that are expected to yield returns higher than the interest rate charged on their personal loan.However, investments that are not linked to any crucial financial goals or yield returns lower than personal loan interest rates can be used for prepaying the personal loan.
5-Determine Whether to Invest or Prepay
When you have surplus funds, you can use it either for loan prepayment or for investment. Which one of the two options should you choose would depend on the savings/ earnings made on either of the two options. Personal loan borrowers should use their surplus for investing in equity and stocks in a bear market as during this phase depositors can avail these instruments at attractive valuations. Moreover, the returns generated through investing in equity over the time can be significantly higher than the savings made on interest cost through personal loan prepayment.
Conclusion
Personal loan prepayment is an attractive option for borrowers as it allows them to lower their loan’s overall interest cost as well as the loan repayment obligation. However, the applicable prepayment/ foreclosure charges (if any) and the reduction in liquidity can discourage borrowers from prepaying their personal loans. Borrowers having restricted or insufficient liquidity can apply for personal loan with lenders offering lower interest rates. Transferring their existing personal loans at a lower interest rate to a new lender would reduce their overall interest cost as well as their EMI obligations.
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