Questions You Should Ask Yourself Before Prepaying Your Loan

Taking a loan, be it a personal loan, car loan, home loan, or two-wheeler loan is a big responsibility. These loans can be a boon during emergencies, but can also be taxing on an individual if he/she fails to plan the repayment. While most of us stick to the minimum requirements, paying a certain EMI for the set tenure, there could be instances where we have received some surplus money, money with which we don't know what to do.

A majority of us end up spending this money on things which catch our attention. Some of us could choose to buy a new phone or a TV, but is this the smartest option?

One thing we can consider is to pre-pay the loan amount (if the money received covers the balance). This might help us save money in the long run, in addition to reducing the stress associated with repaying a loan.

What we fail to do in such situations is a question the feasibility of the different options in front of us. While we have a number of questions when it comes to applying for a loan, these questions seem to vaporise when it comes to situations where we have excess funds.

So if you are someone who has a personal loan or car loan, and has received a bonus from your company/come across a sudden influx of cash, these are a few questions you should ask yourself before you decide to pre-pay the loan.

1. Does my bank prohibit prepayment of a loan?

While most banks permit prepayment of a loan, a number of banks offer products for which prepayment is not permitted. It is imperative that one checks the prepayment policy with respect to the loan taken. If there is no prohibition on prepayment, one could go ahead and ask a few more questions which could help in arriving at a decision. In certain cases banks might not offer the option of prepaying a loan as this reduces their margin, resulting in losses for them.

2. Will I be charged an amount for prepayment?

If your bank does allow prepayment, the next question you should ask is whether you will be charged an amount for the same. A number of banks charge a certain percentage of the outstanding amount as a prepayment penalty. This amount typically ranges between 1% and 3%, with it subject to change as per the prevailing policies of the bank.

For example, if you have an outstanding amount of Rs.1 lakh which you wish to prepay, and your bank has a 2% prepayment penalty, then you will have to pay a prepayment penalty of Rs.2,000. This essentially means that you will end up paying a sum of Rs.1,02,000 in order to close the loan.
With respect to car loans, most loan providers do not charge a prepayment penalty if the prepayment is done after a specified minimum period.

3. Can I invest the money into instruments which pay richer dividends than prepaying the loan?

Prepaying a loan can be beneficial financially, for it can help one save money on the interest which would have otherwise been paid through the loan tenure. It also provides peace of mind, knowing that one's liabilities are reduced. But one should also check the quantum of financial gains of prepayment vis-à-vis investments in other products.

For example, one might save a few thousand rupees on the interest when a loan is prepaid. This prepayment amount, however, if invested in instruments like mutual funds, ULIPS, stocks, etc. could result in higher dividends than the saving provided by the prepayment. It is therefore important to ask this question before choosing to prepay the loan.

4. How will my tenure change on prepayment?

Sometimes we might have money which is not sufficient to clear the entire loan. In this case we might wish to pay this excess sum and could either opt to reduce the future EMIs or decrease the tenure. Choosing a reduced tenure is more beneficial than choosing to reduce the future EMIs, for the interest portion decreases with reduced tenure.

5. Will it impact my credit score?

It is common for us to think that prepaying a loan will help increase the score, but this is not true in all cases. Prepaying an unsecured loan like a personal loan or an education loan help improve the credit score, but prepaying a secured loan like a home loan or car loan can result in a drop in the score, check here for more.

Repaying a loan is a huge obligation and while we may wish to get done with it as quickly as possible, we should not forget to ask questions which could help us reach an answer which is beneficial to us in the long run.