All About Prepayment


What is prepayment?

Prepayment is the settlement of a debt or any loan before its official date. It is a facility offered by banks that helps customers pay their loan amount before the completion of repayment tenure. There are numerous types of debts and obligations that can be settled through prepayment. A prepayment can comprise the settlement of a bill, an operating or a non-operating expense that closes before the due date.

Whether you are an individual, a corporation, or any organization, you can choose prepayment to settle your debts in advance. Corporates may prepay their rent, wages, or other short and long-term obligations. Bank customers can prepay credit card charges or a loan amount by paying the entire debt on their own or through another lender.

However, bear in mind that some loans, for instance, mortgages, might include a penalty in case of prepayment. In such a case, you need to be aware of all the provisions while taking out the loan.

KEY TAKEAWAYS

  • Most banks or financial institutions have a lock-in period varying from 1 to 3 years when you are not permitted to prepay the loan. However, as per RBI guidelines, loans availed at floating rates have no lock-in durations.
  • If the penalty is imposed on fixed-rate loans, then do check if the penalty is going to exceed the savings on interest post prepayment of the due loan amount.
  • Most banks calculate the interest component on the reducing balance method. Therefore, the interest component is higher during the first few years and then reduces as the tenure decreases. Thus, you can calculate the exact savings on interest by following a prepayment plan.
  • Bear in mind that a prepayment penalty clause states that a penalty will be imposed if the borrower pays off the due amount within the first five years of the loan duration.

Advantages of prepayment

Prepayment of your loan amount can offer the following benefits:

Savings on interest amount: If you choose to prepay the outstanding loan amount, it will help you save a lot on interest costs because the loan will not be continued till the completion of repayment tenure. Many people believe that they can save interest costs only by prepaying their loan amount in the early phase of their loan duration. However, you can also save money on EMI payments if you manage to prepay the loan amount in the later phase of the loan duration. Though, you need to consider the prepayment charges and additional costs (if there are any) to determine the net savings while exercising the prepayment option.

Positive effect on credit score: Lenders prefer giving a loan to users or customers with a spotless loan repayment credit report. Full prepayment of the Personal Loan amount can increase your CIBIL score, which in turn, not only helps you close your next loan application successfully but also bargain for some favourable terms from the moneylender.

Reduce debt burden: Lastly, being debt-free has its benefits.

  • You live a stress-free life
  • There is more disposable income in-hand
  • The risk of financial failure reduces to a great extent
  • You attain financial independence earlier than you would have had the loan continued

Disadvantages of prepayment

However, if you choose to pay off your loan earlier than the due date, it may have the following disadvantages:

Prepayment charges: Albeit, RBI has barred all moneylenders from levying any fee on prepayment of Personal Loans availed at floating interest rates, there is no such constraint in case of loans availed at fixed interest rates. So, most lenders impose a penalty of up to 5% on the outstanding Personal Loan amount. Many lenders also restrict borrowers from making prepayment of a portion of the loan amount until they repay a predetermined number of EMIs.

How does loan prepayment work?

Prepayment penalties may vary with respect to your lender and loan type. In some cases, lenders are restricted from charging any fee on prepayment, while some lenders choose not to impose any fee on prepayment. Prepayment penalties often make it more expensive for borrowers to refinance within the first few stages of loan duration.

Let’s look at the below example of Mr X, who took a loan of ₹20,00,000, to comprehend the whole scenario of how this prepayment works.

Particulars Data (Amount in ₹)
Loan borrowed 20,00,000
Interest charges 9%
Loan tenure 20 years
EMIs 17,995
Total interest (in 20 years) 23,18,687
Total payable amount (in 20 years) 43,18,687

Now, let’s assume the borrower chooses to prepay the loan amount in the 11th year.

Particulars (in the 11th year) Amount (in ₹)
Opening balance (Principal) 14,20,518
Prepayment sum 14,20,518
Interest amount saved post prepayment 7,38,825

Here, by making a full prepayment of the balance principal amount in the 11th year of the tenure, Mr X saves ₹7,38,825 in interest and around 119 months in tenure.

Now, let’s see what if he chooses to increase the EMI by ₹5,000 every month post the 10th year.

Particulars (in the 11th year) Amount (in ₹)
Principal (opening balance) 14,20,518
Prepayment increment (monthly) 5,000
Total EMI amount (17,995+5,000) 22,995
Interest amount saved 2,44,067
Loan tenure reduced (in months) 36

So, with the prepayment increment of ₹5,000, Mr X is now able to reduce the loan tenure by up to 3 years which helps him save around ₹2,44,067 on total interest.

Types of prepayment

Prepayment by taxpayers: Taxpayers often (voluntarily or involuntarily) prepay their taxes when a portion of their monthly income is withheld for taxes. Though taxes are due on or around 15th April of each year, their employers are supposed to withhold the taxable amount in each pay period and pay tax to the government on their behalf. Self-employed individuals are expected to prepay their taxes by filing quarterly estimated taxes.

Notwithstanding, whether you are an employee or a self-employed professional, if you have paid tax more than the due amount for the year, you are eligible to receive the excess amount as a tax refund.

Prepayment by corporates: In the case of corporates, expenses are considered under prepayment terminology. Often expenditures are paid in full in the current financial year for goods and services to be consumed in the future year. The prepaid expenditure is first classified as a current asset on the organization’s balance sheet. Later, these prepayments are reclassified as normal expenses when the goods are actually consumed.

Prepayment by individuals: The accounting process of prepayments by individuals is a bit easier. In this case, the borrower might accumulate a monthly credit card bill with a settlement tenure of 30 days post the end of the month.

Effect on credit rating

Although it might be an exaggeration to imagine that prepayment of a loan would have an immediate effect on your credit score, however, in the long run, it would be effective to help you successfully close your next loan application. However, again, if you choose to prepay a portion of your loan amount, it will not affect your credit score, except for the fact that it decreases your loan burden and the total tenure.

Nevertheless, it is always recommended to prepay the entire outstanding amount or prepay a portion of the sum sans second thinking, for the high-interest rates are big rip-offs.

Why do lenders charge a prepayment fee?

Prepayment penalties are actually the disincentives for prepayment of the loan amount, for it eventually causes loss to the lenders on interest income. Had there been no prepayment provisions, it would be easier for a borrower to refinance the loan as soon as they find a better interest rate. So, prepayment penalties are there to protect the lender from the loss of the interest income that would have been otherwise paid over the duration.

However, you need to comprehend that a prepayment penalty does not anyhow prevent you from paying off or refinancing the loan. It allows you to review your loan documents before you zero in on a lender or the loan amount.

Prepayment Vs. pre-closure

Prepayment of a loan is a facility given to the borrower to repay their entire outstanding loan amount or a portion of it before the due date arrives. The prepayment option helps you not only enjoy savings on interest but also gets you out of debt early. Some banks even offer value-added services, such as a zero-balance savings account or a free trading account, to borrowers who opt for prepayment.

Moreover, as mentioned above, RBI has barred banks from imposing any penalty on the prepayment of loans. However, this rule applies only to loans availed at floating rates. As Personal Loans are often offered at fixed rates, this rule is not applicable there.

Foreclosure or pre-closure of a loan is a facility to repay the outstanding principal amount in one instalment before the due date. It not only reduces the interest liability significantly but also helps in closing the loan account before the tenure. To pre-close a loan, you have to make an application to the respective lending bank. Once the bank or the lender calculates the pre-closure balance and finds it satisfactory while considering the total outstanding liabilities, interest paid, and the remaining loan term, you can pay off the due amount and close the deal.

Usually, a Personal Loan has a lock-in period of one year. You can choose to prepay the balance amount after this duration. However, do collect the original documents and ‘No dues’ certificate from the bank after settlement to prevent any further collateral damages.

Final words

Prepayment and pre-closure of a loan is an attractive proposition for borrowers as it allows them not only to save big on interest costs but also helps them get rid of the debt earlier. However, before you exercise these options, it is vital to consider all the factors mentioned above. Only if you are gaining excessively from the entire transaction should you go ahead with it.

Other Words

  • Processing Fee
  • Proprietorship
  • Pre-clousre
  • Partial Disbursement

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