Part-payment, pre-payment, and pre-closure

Difference between part-payment, pre-payment, and pre-closure

One applies for a loan to meet various needs in life. These loans include business loans, personal loans, auto loans, education loans, home loans, etc. After availing of the loan, the next significant responsibility is to repay the same. Each type of loan comes with a specific interest rate.

Borrowers need to pay an installment and the interest every month to clear off the loan amount over a specified period. Some borrowers find interest a bit tiring financially. If that is the case, they can choose prepayment, part-payment, or pre-closure of the loan. Regardless of which repayment schedule you choose, you must understand loan repayment terms to benefit from the same.

What is part-payment of a loan?

The part-payment of a loan happens when the borrower has some idle money, not equivalent to the entire outstanding principal amount. The borrower deposits this amount in the loan account to reduce the unpaid principal amount. As a result, the EMIs and the total interest you pay reduces. However, it is vital to note that you can benefit from this repayment schedule only when you spend a significant amount of lumpsum money as the part payment.

Part-payment is an easy and effective way to reduce interest. The part-payment amount is deducted from the principal outstanding when you make the partial payment. After minimizing your interest outgo, the savings you earn depend on the timing and amount of the part payment. It is not good to make a small part payment, especially if the bank or the lender has prepayment charges.

Part-payment has another advantage. You can make a part payment several times, depending on your capability. Some borrowers make a partial payment more than once, while others make a regular payment of a lumpsum amount. Part-payment will reduce your EMI amounts, and total interest paid irrespective of the payment frequency.

If your bank or financial institution levies prepayment charges on every transaction, you can still benefit by paying back a substantial amount regularly. The interest you save on the whole will be much more. The only drawback in part-payment is that banks may not permit you to do so on specific types of loans, especially personal loans. They set a lock-in period on the term and the part payment amount.

What is pre-payment of a loan?

Prepayment is a facility that lets you repay the loan in part or complete before the end of the loan tenure. Most banks allow you to prepay the outstanding principal amount after one year. This repayment schedule helps you save a lot on interest. Let us understand this with the help of an example.

Ajay takes a loan of Rs. 3 lakh for five years at an interest rate of 15% per annum. His equated monthly installments are Rs. 7,137. He pays an interest of Rs. 35,529 in the first year. The outstanding principal amount after the first year is Rs. 2,64,160. On prepaying the outstanding amount, he saves interest of Rs. 57,049.

The prepayment option lets you save on interest and get out of debt early. Moreover, the bank or the lender may reward you for prepaying your personal loan. For instance, banks provide value-added services like a free trading account or a zero-balance savings account to borrowers who choose prepayment.

However, some banks impose a penalty of 2% to 5% for loan foreclosure. This fee is charged on the outstanding principal amount. You can better understand the figures by using an online EMI calculator. The calculator estimates the cost of the loan and your savings with the prepayment facility. Just fill in the loan amount, interest rate, tenure, processing fee, method of prepayment, and foreclosure charges to get the required results.

The Reserve Bank of India (RBI) has recently instructed banks not to charge any penalty on pre-closure of loans. However, the amendment is restricted to loans taken on a floating rate only. Personal loans are generally on a fixed interest rate, and therefore, the rule does not apply.

What is pre-closure of a loan?

Pre-closure or foreclosure of a loan refers to repaying the outstanding principal amount in a single installment before the end of the loan term. The legal process helps in reducing the interest liability significantly. Moreover, it aids in closing the loan account well before its tenure.

To foreclose or pre-close a loan, the borrower must apply to the respective lending institution or bank. The lender will calculate the foreclosure balance after considering the total outstanding obligations, the remaining term of the loan, and interest paid. If the calculations and the amount is satisfactory, you can pay off the amount and close the loan.

Depending on the lender's terms, a personal loan usually has a one-year lock-in period. You can prepay the balance and settle the loan account after this time. Ensure you collect the “No-dues” certificate and original documents from the bank or lending institution after settlement.

In some instances, the bank or the lender forecloses the loan. The situation arises when the borrower cannot repay the loan amount and defaults on EMI. The lender auctions the borrower's collateral. After the amount equivalent to the outstanding loan amount is raised, the lender forecloses the loan account.

Effect on credit rating

When you make a part payment against your loan, it has a negligible effect on your credit score. It reduces the total loan amount and the interest, making it easier for you to clear the loan on time. But prepayment and foreclosure have a positive impact on your credit score.

Summing up

Many lenders are offering attractive loan options. However, borrowers do not want to be debt-ridden. They want to repay the loan at the earliest. Prepayment and foreclosure facilities allow them to get rid of the debt earlier and save on interest. When they invest their surplus money in their loan account, they reduce the outstanding loan amount, thereby lowering the EMI or the loan tenure.

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