How do personal loan prepayments help to reduce personal loan interest rate?

How do personal loan prepayments help to reduce personal loan interest rate?

In today’s world, getting a personal loan is easy. These loans are also extremely flexible and convenient. As a result, these are one of the most popular financial products. But despite their heavy popularity, most people wish to avoid any possibility of risk and want to opt for the option of pre-closure of the loan as soon as they are able to financially afford it.

Every individual has a myriad of desires they want to fulfil. Credit availability has made the possibility of achieving those dreams a reality even if they are beyond what your monthly income can afford. Personal loans are one such financial tool that can be availed to cater to a specific purpose like buying your dream home, pursuing higher studies, or to expand your new business. The loan and the personal loan interest rate combined give wings to your aspirations.

Personal loans are easy to get and have no end-use conditions imposed upon them. The further advantage of these loans is that they are disbursed soon and need no collateral. They are thus a boon for every dreamer whose dreams are a little bigger than their pockets.

On the other hand, these loans come with a greater degree of risk associated with them since the personal loan interest rate tends to be generally higher than the other types of loans. The personal loan interest rate can vary from 11 percent to a whopping 25 percent per annum. This means that if you were to take a loan of a sum of 200,000 at a 14 percent rate of interest for a term of 5 years, you would have to pay a sum of 279,220 at the end of the term. This suggests that the amount paid in interest was equal to 79,220, which is quite high for somebody with limited finances.

A higher personal loan interest rate also means that there will be a higher burden of EMI on those who opt for these loans, which means living a frugal lifestyle until the loan is paid off. This high EMI charge tends to leave the borrower thinking of ways to pay off the loan at the earliest. One way to rid yourself of the burden of a loan is to prepay the amount borrowed.

Prepayment Possibilities:

There are essentially two ways of prepaying your personal loan. You can either pay off the entire loan at once or pay it in parts. Prepaying a loan is not in the best of interests for the banks as they lose out on the amount charged through the personal loan interest rate. No bank however can stop you from prepaying your loan although they may charge a penalty for doing so. There are pre-closure charges levied by the banks on loans falling in the range of 1 percent to 4 percent of the outstanding personal loan amount.

Let us try to understand this better. Generally, most banks have a lock-in period of at least 1 year. If a borrower wishes to pay off their outstanding principal balance completely or partly, they will have to wait until this lock-in period ends.

 Let us now look at the advantages of prepaying a loan as well as the steps one needs to take in order to close off their personal loan:

Advantages of Prepaying Personal Loan:

Before the scheduled term ends, the borrowers can repay their loan using the loan prepayment option. One can choose to either pay it fully or partially, thereafter relieving themselves of the debt obligation before the tenure gets over. It is usually a win-win situation for the borrowers, let’s see why:

Getting Debt-free Quicker- When an individual decides to prepay their loan, their debt obligation ends faster than they had initially planned. Getting rid of this obligation also frees you from having to pay any more EMIs. You also end up preserving your savings by not having to pay EMIs.

Build credit Score- A credit score is built on the basis of an individual’s credit actions. While any default in your bill payments will have a negative effect on your credit score, prepaying a personal loan has a positive impact on it. At the same time, by closing off your loan successfully you also lessen the amount of debt stated on your credit portfolio. This reduction adds an additional positive point to your overall credit score.

Save the Interest Amount- The personal loan interest rate applicable to the principal significantly constitutes loan repayments. By prepaying your personal loan, you are not only able to reduce the outstanding principal amount but at the same time you also end up saving your expenditure on interest. The amount thus saved can be used for further investment, earning you interest in return.

Reduced Personal Loan Interest Rate: If you choose to partially prepay your loan amount, the new interest rate will be calculated on the basis of your outstanding principal amount. As a result, personal loan prepayment will help to reduce the interest rate and save some extra money in your bank account.

How does personal loan prepayment work?

First, let us understand how personal loan part prepayment works:

If you have surplus money, you can use it to make partial payment of your personal loan after the lock-in period is complete. This partial payment will help reduce the total outstanding principal of your loan.  The personal loan interest rate charged will now only be limited to the reduced outstanding principal amount, thereby allowing you to save more money. Here is an example to explain this better:

For instance, you borrow a personal loan of 400,000 at a personal loan interest rate of 14 percent for a period of 3 years. During the lock-in period of 1 year, you will be able to pay off an amount of 115,263 out of the total principal. The remaining outstanding balance will be 284,737.

A part prepayment of a sum of 100,000 after the completion of the lock-in period will bring down your outstanding principal to 184,737. The new personal loan interest rate will be calculated keeping this number in mind, thereby saving you a significant amount.

Now let us take the same example to see how a complete prepayment of your personal loan can be done:

On a personal loan of 400,000 charged with a personal loan interest rate of 14 percent for 3 years, let’s say the EMI charged is 13,671 per month. One will have to pay 92,158 as total interest during the term of the loan. During the lock-in period of 1 year, one will have to pay a sum of 48,790, which is around 52 percent of the total interest charged. Therefore, by paying off the complete principal amount at once will save 47 percent or 43,368 of the interest cost. Even if you don’t prepay the entire loan immediately after the lock-in period end, you will still be able to save up a significant amount of the interest cost.

Things to be Careful of during Personal Loan Prepayment:

Even though paying your personal loan before the term is over is usually a win-win situation, there are some things you need to keep in mind:

Reduced Cash Liquidity: Once you pay off your entire loan, you might have to face a sudden crunch in cash liquidity. This will be a problem in case you are planning a major event like a vacation or wedding or if you are planning to buy something expensive.

Face Penalty: As mentioned before, you might have to pay a small percentage of prepayment charge for paying off your personal loan before the closure of the tenure. This penalty amount varies from one bank to another. While some banks choose to impose a flat rate on the amount of loan, other banks might impose a penalty based on the number of months of interest they are losing. If you are planning to prepay your loan, try to borrow from a bank that has no or low prepayment penalty charges.

The Bottom Line

Prepaying your personal loan can benefit you in many ways like a reduced personal loan interest rate as well as tons of savings but carefully investigate whether your bank imposes a penalty on complete prepayment or partial prepayment of the loan. Weigh in all your options to figure out which is the most beneficial for you- paying the penalty charges or saving the interest cost and only then plan your next move.