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To prepay or not to prepay?
Given the Indian aversion to debt, it is hardly surprising that many loan owners are eager to prepay their loans as and when their finances look up. However, this is not always the most economical option and one should consider various factors before deciding on this course.
What is prepayment?
When a borrower pays off his/her loan entirely or in part before the defined due date, it is termed as prepayment.
When considering prepayment, borrowers need to ensure that they factor in the following aspects:
- Prepayment penalties
Prepayment penalties vary from one financial institution to another, and often, even from loan to loan. These penalties are either charged at a flat rate, or at a certain number of months’ interest. Even if the loan contract does stipulate a prepayment fee or penalty, a loan owner must first compare this amount against the overall interest he/she will save in terms of interest. Also, in some instances, the prepayment is made possible after a minimum stipulated period of loan ownership. To make sure they are able to capitalise on these provisions, borrowers must first carefully read their contract or talk to their borrower at length.
- Actual savings
Loan owners often presume that because they have already paid a substantial number of EMIs, the interest component is much lower, and it hence makes little sense for them to prepay the loan amount. The truth, however, is that the borrower pays the same interest for the unpaid principal amount, since the interest is calculated using the reducing balance method. When considering prepayment, borrowers should hence consider the prevailing interest rate, rather than the loan tenure.
Whether or not to prepay your loan depends on many factors such as the stage of loan payment you are at, the interest rate, and the prepayment charges. An analysis of these elements is a must before you decide to take action.