Personal loan is considered to be one of the fastest and easiest loan options for those who are in urgent need of funds. Although its interest rate may be relatively higher, there is no restriction on end use. However, given a general inhibition on debt, borrowers often try to prepay their loans with excess funds, when available. Note that opting for early repayments on personal loans may be an optimal option at any time.
If you are among those considering partial payment or prepayment of a personal loan that you received during the time of crisis and need for money, Gaurav Aggarwal, Director of Unsecured Loans, Paisabazaar.com shares a list of the 6 main factors to consider before opting for the prepayment of personal loan. Borrowers should keep in mind these points before going ahead with the loan prepayment option available on personal loans: –
1- Prepayment / foreclosure fees
Because the RBI has prohibited lenders from penalizing prepayment of a variable interest rate retail loan, the available variable rate personal loan does not incur a prepayment charge. On the contrary, personal loans available at fixed rates incur a prepayment charge of up to 5% of the outstanding principal on the lender’s basis.
Note that most lenders offering fixed rate loans do not allow partial prepayment of the personal loan. On top of that, few lenders do not allow partial prepayment before borrowers pay off a predetermined number of loan EMIs.
The reason for opting for early repayment of the loan is to save on interest charges. However, there is a widely held misconception that only prepayments made at the start of the loan can lead to interest savings, and not at later stages of the loan term. In fact, interest savings can also be realized at later stages. Use online personal loan prepayment calculators to find out about the interest savings on prepayment. Choose this option only if you are able to save a considerable amount after factoring in the prepayment charge, if any.
3-Impact on the emergency fund
Ideally, your emergency fund should be enough to cover your mandatory monthly expenses for at least 6 months. These expenses should include your insurance premiums, living expenses, loan EMIs, rent, utility bill, children’s school fees, etc. However, many personal loan borrowers tend to use their specific emergency fund allowances to prepay their personal loans to reduce interest. Cost. It can seriously damage your financial health, because in case of financial requirement or loss of income due to illness, disability, job loss etc.
4-Returns of existing investments
The potential returns from existing investments such as term deposits, mutual funds, insurance policies, etc. should also be taken into account when deciding on early repayment of the loan. Avoid buying back high yielding investments or investments that are expected to generate higher returns compared to the interest rate charged on your personal loan.
Low-yielding investments in short-term debt funds, term deposits, etc. unrelated to a critical financial goal can be liquidated to prepay your personal loans, as the returns generated by these instruments are typically lower than the interest rate charged on personal loans.
5-Opportunity cost of not investing
In the context of prepayments, the opportunity cost is the lost opportunity to earn higher returns by channeling excess funds for prepayment of the loan, instead of investing. In other words, it is the difference between the returns on investment that you forfeit to make prepayments of loans and the interest savings generated on prepayments.
The opportunity cost of not investing is considerably higher for stocks and equities during the bearish market phase or strong market corrections, when they can be exploited at attractive valuations. The returns generated by investing in stocks under market conditions can be considerably higher than the interest savings on prepayments of personal loans.
6-New loan request
Most lenders give preference to loan applicants with an EMI to Monthly Net Income (NMI) ratio of 50%. This includes the IMEs for the existing loan as well as for the new loan. Therefore, existing personal loan borrowers who are considering taking out another loan, such as a home loan or car loan, and who exceed their EMI / NMI ratio can improve their chances of loan eligibility by prepaying their personal loan. ; thus lowering their EMI / NMI ratio.