What is loan prepayment and how it works?
February 12, 2020
Many individuals look for different ways to either reduce or consolidate their debt. One of the ways widely popular among borrowers is repaying the loan in part or full before the full tenure of the loan. While it can reduce your debt, it can also lead to huge savings that you may otherwise pay in the form of interest.
Many banks now offer the pre-payment facility to make this possible. Let us have a look at what is loan pre-payment and how it works.
What does prepayment of loan mean?
As the name suggests, pre-payment is a facility offered by some banks to help a borrower repay their loan before their actual repayment tenure as per the loan documents. The pre-payment can be done in parts or in full.
How does loan prepayment work?
To understand this, let us look at the following example of a Home Loan taken by Mr X from his preferred bank.
|Loan particulars||Loan details|
|Total interest amount (in 20 years)||23,18,687|
|Total amount payable (in 20 years)||43,18,687|
Now, let’s assume he chooses to pre-pay the loan in the 11th year.
|Opening balance (principal)||14,20,518|
|Interest amount saved||7,38,825|
The working of loan pre-payment depends on whether you are going for part-prepayment or full-prepayment. With part-prepayment, you get to repay a certain lump sum amount from the total loan amount. As you can see in the example above, by making a full pre-payment of the balance (principal) amount after the end of 10 years, Mr X is saving Rs 7,38,825 in interest and about 119 months in tenure.
And, if Mr X chooses to increase the EMI by Rs 5,000 every month from the 11th year, this is how it is going to look like.
|Opening balance (principal)||14,20,518|
|Prepayment amount monthly||5,000|
|Total EMI (17,995+5,000)||22,995|
|Tenure reduced (in months)||36|
Just by increasing EMI by Rs 5,000, Mr X was able to reduce the tenure by up to 3 years resulting in total interest savings of Rs 2,44,067.
Benefits of loan pre-payment
Now that you know how loan pre-payment works; let us have a quick look at some of its benefits.
- Any pre-payment towards the loan goes directly towards the principal and not the interest.
- Loan pre-payment can help you consolidate your loans.
- Considerable savings on interest.
Pre-payment with multiple loans
Borrowers who have multiple loans can use the pre-payment feature to consolidate their debt. More importantly, pre-payment loan can be used to switch from high-interest-rate loans such as Personal Loans to low-interest-rate options such as Home Loans, Loan Against Property, etc. If you are someone who wishes to consolidate your loan, check out various loan options and evaluate accordingly.
Points to keep in mind before pre-paying a loan
While loan pre-payment is known to be highly beneficial, there are a few things every borrower should know.
- Prepayment lock-in period: Most banks have a lock-in period ranging from 1 to 3 years, during which you are not allowed to pre-pay the loan. However, floating-rate loans have no lock-ins as per RBI guidelines.
- Prepayment penalty: A penalty may be charged for loan pre-payment before the end of the lock-in period (for non-floating rate loans and business loans). Do check this penalty is going to exceed the savings on interest.
- Interest rate of loan: The interest component of the loan is calculated on the reducing balance method by most banks. This means that the interest component is higher during the beginning and reduces as the tenure decreases. A loan pre-payment calculator can help you find out the exact interest you can save by following a pre-payment plan.
To pre-pay or not to pre-pay?
The decision between the two depends on a number of factors such as type of loan, interest rate, pre-payment penalty, loan tenure and more. Moreover, the rules regarding pre-payment vary between banks. So, make sure you check with your bank before signing on the loan agreement.
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