What is a prepayment penalty?

Personal loans have seen a huge rise in recent days. More and more people are going for personal loans, especially after fintech companies appeared on the scene. The easy availability of funds and credit through these new-age finance companies has soared the personal loan market. You can now avail yourself of personal loans with just a few clicks. Further, the benefits that a personal loan carries make it a go-to funding option at any time. However, many people prefer to prepay such loans even though banks levy a prepayment penalty on personal loans. What is the prepayment penalty? Is prepayment beneficial? Let’s find out!

What is the prepayment of personal loan?

Personal loans are short-duration loans. The tenure usually ranges from 1 year to 5 years. But many a time, people end up taking personal loans for a longer tenure than required. Once their purpose is fulfilled and they have sufficient funds available, they repay their loans in advance of the actual due date. This is known as the prepayment of a personal loan. Prepayments are of two types:

• Part- or partial-prepayment: Here, only a certain portion of the personal loan is prepaid. For instance, if the principal outstanding is Rs. 5,00,000 and you prepay Rs. 1,50,000, then it will be considered part of the prepayment of a personal loan.
• Full repayment: Here, the entire principal outstanding is repaid before the term of the loan expires. Continuing the above example, if the entire amount of Rs. 5,00,000 is repaid, then it will be considered a full prepayment.

Whether prepayment and foreclosure are different

You might have come across the term “foreclosure” as well. Prepayment and foreclosure are two different things. Prepayment is usually used to indicate partial repayment of a personal loan. But foreclosure occurs when the remaining loan amount is repaid in full. It is the legal term to denote the closing of the loan before the loan term expires.

Full prepayment forms part of the foreclosure. Another way of foreclosing is when you transfer your loan from one bank to another. Borrowers usually transfer their loans from one bank to another because of lower interest rates, better terms, etc. In such a case, the second bank pays the outstanding balance to the original bank. The borrower will then repay his loan to the second bank.

Benefits of prepayment

Following are some of the key benefits of prepayment:

• Eliminates Debt: Prepaying your personal loan helps you eliminate your debt if you make a full prepayment. Even if you make a partial prepayment, your debt can be reduced to a great extent.
• Savings on Interest Cost: Personal loans carry a huge interest rate. Prepaying your personal loans can help you save a tonne on interest costs. Personal loan interest rates start at 12%–14% and can go as high as 18% per annum. Hardly any asset class provides that kind of return. As the saying goes, “each penny saved is a penny earned.” Prepaying your personal loans can help you save on such high-interest costs, which are equivalent to earning such high returns.
• Better Interest Rates: If you go for transferring your personal loans to another bank, then you can earn better interest rates and get better terms for your personal loans. This is the sole reason why many people go into foreclosure on their loans.
• Impact your Credit Score: Prepayment reflects positively on your credit report. If you prepay your personal loans, it can increase your credit score.
• Better Chances for Loans in the Future: If you prepay your loan, your outside liability gets reduced. Therefore, it opens the door for more credit access in the future. While availing of loans, your current debt obligations are considered. They might impact the amount of loan that you can borrow or the interest rate. You can avail of a higher loan amount in the future because of more disposable income in your hands.

Prepayment Penalty on Personal Loans

Prepayment penalty on personal loans varies among different banks. Most banks levy prepayment charges only for a specified period. Beyond that, there are no charges for prepayment. Furthermore, charges for partial repayment and full repayment may differ. Also, certain banks waive the prepayment penalty on personal loans if the loan is transferred to another bank. Usually, the prepayment charges range between 1% and 4% of the amount being prepaid or the principal amount outstanding.

Should You Go For Personal Loan Prepayment?

You need to consider various factors before opting for personal loan prepayment. These factors include the following:

• Prepayment Penalty: What is the prepayment penalty on personal loan that the bank is going to charge? You need to understand this before going for prepayment. Go through the sanction letter or loan documents to know the prepayment penalty.
• Principal Amount Outstanding: What is the principal amount outstanding? If it is only a nominal amount, prepayment will not provide much benefit.
• Current Interest Rate: What is the current interest rate that you are paying on your personal loan? You should consider prepayment if the interest rate is too high. Otherwise, you can consider investing the excess funds that you have.
• Tenure Remaining: What is the loan tenure remaining? Again, prepayment won’t be very beneficial if it’s only for a few months or a year.
• Mode of Prepayment: How are you going to prepay your loan? You might be considering transferring your loan to another bank. But you will have to pay processing fees and other charges.
• Opportunity Cost: The opportunity cost of not prepaying your loan is the investment opportunity that you missed. So, the interest you save through prepayment must be higher than the returns you could have earned from investments.

Conclusion

The prepayment penalty on personal loan makes it important to carefully consider whether to prepay or not. Considering the above factors will help make the same decision. Visit Piramal Finance now for more useful information!