Personal Loans are the most popular financial product, whether for travel, festival celebration, gadget purchases, or wedding. They are dependable, adaptable, and easy to obtain, requiring no security. Despite its ease, it is also one of the most expensive.
Many borrowers consider prepaying or foreclosing their existing Personal Loans due to the high-interest costs and EMI burden associated with them. While Personal Loan prepayment is usually a good idea for borrowers, they should do a thorough cost-benefit analysis to guarantee a sound decision.
How can you maximize a Personal Loan's benefits while lowering its cost? The answer is prepayment.
What is Prepayment?
Prepayment is when you pay off your outstanding loan amount in whole or part before the loan agreement's due date. The prepayment clause specifies that if you pay off your loan before the agreed-upon term, the lender will charge you a fee equal to a percentage of the total loan amount, i.e., foreclosure charges on the Personal Loan.
Paying off the debt ahead of schedule may feel free, but is it always the best and most cost-effective option? Let's find out.
1. Full Prepayment
A Personal Loan typically has a one-year lock-in term, after which you can prepay the entire balance, saving a significant amount on interest. However, you will still pay interest if you pay in advance. The rates may differ from one lender to another, ranging from 3% to 5%. You might be surprised to uncover public or private lenders and lending institutions that don't have foreclosure charges on Personal Loans. As a result, in a cash emergency, you can get instant cash without burning a hole in your wallet due to excessive interest rates.
2. Part Payment
You might choose a part payment option if you have available cash that is insufficient to cover the total outstanding principal amount but can significantly reduce your loan burden. It can reduce the amount of owed principal, lowering your EMIs and real interest. If you choose this option, make a partial payment as soon as possible to save money by lowering your interest rate.
To live a debt-free life, most borrowers will choose the prepayment option. Apart from the economic effects, it will relieve you of the burden of making monthly payments for many years.
Prepayment: Pros and Cons
So, clearing debt before the end of your term seems a wise way to relieve financial stress. Let's look into the pros and cons to assist you in deciding.
Pros of Prepayment
1. Interest Cost Savings
Paying off a Personal Loan saves borrower’s money on interest costs that they would have paid if the loan had been kept open for the entire period. For instance, the EMI will be ?22,753, and the total interest cost will be around ?3.65 lakhs if a loan applicant seeks a Personal Loan of ?10 lakhs for a 5-year term at a 13 per cent annual interest rate. They will save roughly ?2.09 lakhs in interest expenses if they settle the outstanding loan amount after one year.
Many Personal Loan borrowers believe they may save money on interest solely if they pay off their loan early in the term.
They can also save money on EMI payments if they pay off their debts sooner rather than later. To calculate the overall interest savings from prepayment/foreclosure, they should use an online Personal Loan prepayment calculator. Borrowers should, however, consider prepayment fees and other additional expenditures (if applicable) when calculating the net savings from using the prepayment option.
2. Increase Borrowers' EMI Affordability
Banks/NBFCs like to lend to Personal Loan applicants whose total EMIs, including existing EMIs and the EMI for new loans, are between 50% and 60% of their total monthly income. As a result, customers surpassing this limit have a decreased probability of getting a Personal Loan. Prepaying an existing Personal Loan and thereby reducing their EMI/NMI ratio within 50 per cent to 60 per cent of their monthly income can help these borrowers improve their loan eligibility.
3. Reduces the share of Unsecured Loans in the Credit Mix
The credit mix is the proportion of total outstanding secured and unsecured loans or other credit facilities. You can calculate individual credit ratings using this ratio by credit bureaus. Borrowers with a higher percentage of loans in their loan portfolio get higher credit scores from credit bureaus.
Because Personal Loans are unsecured, they will reduce the proportion of unsecured loans in the credit mix if they repay them early. As a result, a higher percentage of secured loans might boost borrowers' credit scores, increasing their chances of getting another loan.
4. Increasing your CIBIL Score
Full foreclosure or payback of a current loan is a significant credit booster because it raises your CIBIL score and establishes a clean credit history. It will immensely assist you in obtaining loans and negotiating conditions with lenders in the future.
Cons of Prepayment
Prepaying a Personal Loan, despite its advantages, comes at a high cost: you'll have to make lump-sum payments to erase the balance, limiting your financial flexibility temporarily.
The RBI has prohibited all lenders from charging prepayment fees on Personal Loans with adjustable interest rates. On the other hand, borrowers who take out Personal Loans with fixed interest rates are not subject to this restriction. Prepayment penalties of up to 5% of the outstanding principal amount of a personal loan are common. Prepaying a Personal Loan at a fixed rate can diminish interest savings. Many lenders also prohibit part-payments or foreclosure charges on Personal Loans until they receive several payments.
Many borrowers deplete their liquid assets or existing investments to repay their loans. However, doing so may jeopardize their ability to deal with any financial emergency that arises from events such as loss of income, medical troubles, or other unforeseen circumstances. Borrowers may have to take out loans at a higher interest rate to accomplish unavoidable financial goals if they tap into current investments for that purpose. Existing Personal Loan customers should only choose prepayment if they have sufficient emergency finances to avoid this issue. They should also refrain from leveraging existing investments for unavoidable financial objectives.
So, before you decide to foreclose or prepay your loan, consider these variables and carefully consider the prepayment penalties, additional interest, and whether or not it would benefit you.
Prepayment is when you pay off your outstanding loan balance in part or entire before the end of your term.
Existing borrowers will find prepayment of a Personal Loan appealing because it helps them minimize their interest payments and overall repayment load. However, if the lender imposes prepayment penalties and a reduction in liquidity, this can be a deterrent. Borrowers with limited liquidity can lessen their repayment burden and interest costs by refinancing the Personal Loan with a lender that offers lower Personal Loan interest rates.
Why do individuals, firms and businesses choose to borrow money from lenders? This is all because we need the money for all the situations.
Personal loans have made our lives easier and more convenient. From tackling a medical emergency to planning a dream vacation with your family to renovating your house, you can get a personal loan and meet all your financial requirements without any hassles.
As a business owner, your reliance on traditional banks is quite understood. After all, very few businesses can survive unpredictable business cycles and manage headwinds without availing of a business loan.