Dos and Don’ts of Personal Loan Prepayment
Most people resort to personal loans, especially during financial emergencies, due to their unsecured nature, easy accessibility, quick disbursal and flexible end use. However, due to its high interest rates, many borrowers choose to prepay their personal loans whenever they have surplus funds. While prepaying a personal loan is usually beneficial, there are still a few things that borrowers should consider to determine its suitability. Here are some key dos and don’ts to consider before prepaying your personal loan.
Dos of Personal Loan Prepayment
Review Prepayment and Foreclosure Charges
Before making any prepayment, check whether your lender imposes charges for part-prepayment or foreclosure. As per Reserve Bank of India (RBI) guidelines, banks and NBFCs cannot charge such penalties on floating rate retail loans, including personal loans. However, this regulation does not apply to fixed rate personal loans. In such cases, lenders may impose a fee – usually up to 5% of the outstanding principal. Some lenders may also restrict prepayment or foreclosure until a certain number of EMIs have been paid. Make sure to review your loan agreement for these terms.
Calculate the Net Savings from Prepayment
The primary reason for prepaying a personal loan is to reduce the total interest cost. While it is commonly believed that prepaying during the early stages of the loan tenure yields maximum savings, doing so in the later years can also offer benefits. Use online prepayment calculators to assess your potential savings. Ensure factor in all the associated costs, including any prepayment or foreclosure charges. Proceed with prepayment only if it results in substantial interest savings after considering these expenses.
Compare Prepayment Savings with Investment Returns
If you have surplus funds, consider whether investing the amount might offer better returns than prepaying your loan. For instance, during a bearish market phase, investing in equities or stocks can be more profitable due to lower valuations and higher long-term return potential. In such cases, the gains from investment may outweigh the interest savings from loan prepayment. Evaluate both options carefully to determine which is more financially rewarding.
Don’ts of Personal Loan Prepayment
Using Your Emergency Fund for Prepayment
Financial emergencies can easily eat away your finances; therefore, building and maintaining an emergency fund should be crucial for everyone. It should ideally cover at least six months’ worth of essential expenses, such as rent, EMIs, utility bills and insurance premiums. Some borrowers use their emergency fund to prepay loans, hoping to save on interest. However, this can leave them vulnerable during unforeseen financial crises. In such situations, the absence of sufficient emergency funds may force them to take out high-interest loans or redeem long-term investments prematurely – greatly hampering their financial health.
Redeeming High-Yield Investments
In a rush to repay their loans, some borrowers redeem their high-yield investments like mutual funds, insurance plans or fixed deposits – often without doing a proper cost-benefit analysis. This can lead to greater loss if the returns from these investments exceed the loan’s interest rate. If prepayment is necessary, prioritize using funds from investments not tied to important financial goals or those yielding lower returns than your loan’s interest rate.
Final Thoughts
Prepaying a personal loan can effectively reduce both your interest cost and overall repayment burden. However, it’s crucial to consider associated charges and the potential reduction in your financial liquidity before prepaying the loan. If liquidity is a concern, consider transferring your outstanding personal loan amount to another lender offering a lower interest rate. A personal loan balance transfer can help reduce your EMI as well as your total interest outgo.