Personal Loans are loans taken to meet any type of personal expenses e.g. medical, marriage, family function, education, vacations, travel, home purchase, improvements etc. No security is needed but qualifying criteria is stringent and banks are more than happy to entertain qualified individuals with minimal paperwork.
Is Prepaying A Personal Loan A Good Idea?
Personal loans are cheaper than credit cards but more expensive than home loans. So if you have taken a personal loan and are thinking about prepaying the personal loan you must base your decision on prepayment keeping the following things in mind.
Firstly you must be aware of the Method of calculation of Interest Rate for your personal loan. This is very important to know in order to compare other options (interest rates) available to you.
Personal loans are usually given by either Flat rate, Reducing Balance or Advance EMI (normally used for consumer durable loans). In the flat rate methodology, the Interest charged is basically Simple Interest.
So if you take a personal loan of Rs 2,00,000 at a flat rate of 15%, your interest is going to be Rs 30,000 per year for tenure of loan.
In the case of Reducing Balance, the EMI and the Interest computation is equated in EMI’s over the tenure of the loan and then you are charged. The Interest is charged on the Balance Outstanding. So effectively this means that between going for 10% flat and 10% reducing EMI method for same tenure, the reducing methodology is a cheaper option.
In Advance EMI lenders/banks normally take 2-3 EMI’s in advance effectively reducing your principal amount. Interest is charged on the entire amount instead of the reduced principal interest.
So basically, for a loan of Rs 2,00,000 with 3 advance EMI’s (Rs 30,000) of Rs 10,0000 your loan may actually be for 1,70,000 but you may be charged interest on the entire Rs 2,00,000.
Therefore, once you are aware of the method of calculation of interest for your personal loan you can consider the various options available at the time of prepayment and make a sound judgment on the prepayment of loan.
Secondly, an important factor to consider is the foreclosure penalty that you will have to pay while foreclosing (early payoff of loan) your loan. So if you have gone for a 1 year, 2 year, 3 year, 5 year personal loan and you decide to foreclose the entire amount, then banks charge you about 4%-5% as foreclosure loan.
The reason is because at the time of taking loan they have quoted you a competitive rate based upon a set tenure. So if you think that you have money available to you through other means and that the 4% cost is something you are willing to incur, you can make prepayment of your loan.
Also, when the bank offers you the option of pre-payment it does not give the flexibility of part payment . If you decide to repay the loan earlier than the pre-determined period, you have to pay the whole outstanding principal. If you have a minimal surplus available to pay a part of your loan that would reduce your interest burden, but the bank does not allow it.
Finally, the decision is based taking into account the above mentioned factors along-with the Interest rate scenario at the time of deciding to prepay. If Interest rates have risen since the time you have taken your personal loan it would make sense to continue with the loan.
However if interest rates have fallen since you have taken personal loan it may be worth considering taking another personal loan (with reduced interest rate) in order to pay off the more expensive loan on the condition that the bank allows you to do so and after taking into account the various costs (processing fees of new loan, cost of foreclosure of old loan, etc) prepayment would still be the cheaper option.
The author is a Certified Financial Planner, working as Senior Manager with Mumbai-based SRE Financial Planners.