Loans play an important role in shaping your credit profile. Debt, at least in terms of your credit health, is good, as you can only establish your creditworthiness by availing of loans. With soaring inflation and rising cost of living, most of us inevitably apply for loans. From personal and business to car and home loans, you can find a wide variety of loans offered by banks and NBFCs catering to the varied needs of customers.
While loans for relatively small-ticket items, such as gadgets and home appliances that you can purchase from online marketplaces, are easy to obtain and repay, the same cannot be said for large amounts. For example, if you are applying for a personal loan to fund your higher education or pay for marriage expenses, you will have to meticulously plan your finances.
It is here that you must understand the importance of prepayment and how it can significantly reduce the total amount you repay to the lending institution.
Importance of prepayment
Most lenders sanctioning large loans, such as car or home loans, allow you to make prepayments. Essentially, a prepayment is the extra amount you pay on top of the regular EMI to reduce the loan principal. You do this when you wish to reduce the total interest you pay to the lender or want to close the loan faster.
When you make EMI payments, they comprise two components: principal and interest. Lenders charge interest ranging from 6% to well over 20%, depending on factors like the loan purpose, your credit score, and your repayment history. The higher the rate of interest per annum, the more you pay as the interest component.
For example, let us assume you have taken a loan of Rs. 30 lakhs. You agree to make EMI payments over a period of 10 years, and the lender is offering an interest rate of 9%. Here, the EMI you must pay per month is Rs. 38,003. Over the 10 year period, you cumulatively pay Rs. 45,60,328. Thus, the total interest you pay to the lender is Rs. 15,60,328—more than half the original loan amount!
You can reduce this interest component by making additional payments (prepayments) to reduce the loan principal.
Important points to remember about prepayments
- Reduces the interest component: By paying off a significant part of the loan principal, you also reduce the interest component, which is calculated based on the remaining loan principal. This ensures you don’t pay a significant amount as the total interest.
- You can shorten the loan tenure: Another benefit of making partial prepayments is shortening the loan tenure. If you want to close the loan faster than originally expected, you can make prepayments to reduce the loan principal.
- Gives you flexibility in managing EMI: Our financial situation can change at any time. If, for whatever reason, you want to pay lower EMIs or shorten the repayment period, you can make partial prepayments to reduce the loan principal. This allows you to cut down the tenure by almost half, so you can close the loan faster.
- Has greater impact in early years: In terms of interest savings, making a prepayment during the early years of the loan tenure has the greatest impact. This is because the majority of the interest is usually paid in the early stages.
- You must check for prepayment penalties: Another important aspect to consider is the prepayment fee. While most lenders allow you to make prepayments without additional charges, some lenders might charge a certain penalty fee. It is important that you read the fine print and inquire about these charges before you apply for the loan.
Conclusion
Whether you are applying for a personal loan or a home loan, first, inquire with the lending institution if you can make prepayments in the future. It is also important to clarify if the lender charges any penalty fee for making prepayments. Making a lump sum prepayment or partial prepayments can be advantageous, as you reduce the loan principal, thereby significantly lowering the total interest amount against the loan. You can use a loan prepayment calculator to calculate the EMI and tenure after making the prepayment and make a sound financial decision.