Loan Prepayment: What It Means, How It Works
Every person that borrows a loan looks for ways to reduce the debt burden. Prepayment is a good solution towards this end.
What is loan prepayment?
Prepayment of a loan simply means that the borrower repays the loan before its tenure is up. It is a facility that the lending institution offers with or without foreclosure charges. The RBI mandates that banks, NBFCs and loan apps may not charge prepayment charges to a customer provided the loan is repaid under certain conditions (see the section ‘Prepayment terms and conditions’).
Hence, you may prepay the loan in parts or in full before its tenure is complete. For example, you have borrowed a small loan of Rs 2,00,000 for a tenure of 12 months. You may choose to foreclose the loan in just seven months by prepaying incremental sums over and above the monthly EMI.
You can prepay the loan with periodic lump sum amounts. Every time you do so, the lender adjusts the principal borrowing accordingly. Thus, the next amount payable in terms of EMIs and the spread of the loan (i.e. number of EMIs still pending) are adjusted and proportionately lowered by the ‘reducing balance’ method. If you pay a large chunk of money, your EMI may be reduced proportionately.
How does prepayment help?
Every loan is repaid in a series of EMIs, i.e. equated instalments every month. Each EMI is composed of the principal borrowing, and the interest payable on the loan. The proportion of these two components is decided by the lender. In case of home loans and long tenure loans, the first few years of the repayment largely comprise repaying more interest than the principal. However, personal loan EMIs are more evenly proportioned.
Thus, the sooner you foreclose the loan, the better for you since you pay less by way of interest money. It also makes you debt-free sooner rather than later.
Prepayment terms and conditions to note
Are you looking to prepay the small loan you borrowed from a loan app? Read these general terms and conditions before you proceed:
Though the loan app allows you to prepay the loan without extra charges, you can do so only after the loan’s lock-in period has elapsed.
The lock-in period is decided primarily by the loan tenure and the nature of the interest rate (fixed or floating). Thus, you cannot prepay the loan in the very next month after borrowing the loan. Some lenders offer a floating rate of interest on personal loans, in which case the RBI mandates that there will be no lock-in period for prepayment.
In case the lender levies a penalty for repayment before the lock-in period, check if it is greater than the savings on interest. If not, it is better to pay the penalty and close the loan.
Tips to prepay your personal loan
Have you decided to prepay your loan to save on interest money? It takes some planning to do so.
Get a detailed calculation with respect to EMI composition: how much principal and interest are being repaid with each EMI. This helps you understand the EMI and interest component much better.
Save a portion of your income every month towards prepayment. You may repay smaller sums every month, or wait to accrue a large amount and pay a lump sum. Paying a lump sum reduces the principal borrowing appreciably.
Ask for the revised EMIs and recalculated pending balance once you make the payment. This helps you check how much money you still owe the app and how many more prepayments you can make.
If the app allows it, ask for the EMI spread to be reduced. Though this increases your EMI amount, it shortens the tenure so you can be debt-free sooner. However, try this option only if you are confident of foreclosing early.
If the loan is a short tenure one, say for six months, then prepayment is neither feasible nor allowed by the lender. Just repay the loan via your regular EMI schedule.
Conclusion
Prepaying a loan is a wise financial move to save interest money. But the lender’s terms and conditions on prepayment must be checked before attempting the payments.
