Repaying a personal loan prior to the completion of its term can look like a sound fiscal decision. It lowers debt, saves interest expenses, and releases liquidity. However, pre-closure is not always the most advisable decision since the lender tends to impose penalties, and utilising a large amount for repayment affects liquidity. Borrowers must consider the advantages over the probable disadvantages before making a choice to ensure that it is in line with their fiscal objectives.
Benefits of Pre-Closing a Personal Loan
The major benefit of pre-closing a personal loan is the saving on interest payments. Personal loans have a high interest rate, and because interest is payable on the principal amount remaining outstanding, an early payment decreases the cost of borrowing. This is useful in the case of loans with long tenures remaining, where most of the interest value is yet to be repaid.
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Another benefit is improved financial health. Erasing debt enhances the creditworthiness of the borrower as a lower outstanding amount positively impacts the credit score. Pre-closure also frees up income that would otherwise be used to pay EMIs, allowing borrowers to invest elsewhere or cover essential expenses.
Financial security is another consideration. Being debt-free is less worrisome in the finances and gives greater room to control personal finances. This is particularly valuable for a person who is expecting big future charges, such as buying a home or maybe unexpected medical expenses and wishes to enhance cash liquidity.
Disadvantages of Pre-Closing a Personal Loan
Though the benefits are there, pre-closure of a personal loan is not always advisable. One of the major disadvantages is prepayment charges. The lenders usually charge a penalty for paying off the loan in advance to recover for their lost interest revenues. The charges usually range between 2 per cent and 5 per cent of the outstanding balance of the loan, which can neutralize the benefits of saving interest.
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Another factor to consider is liquidity. Paying a lot of money upfront to settle a loan could cash-swamp finances, with the lender having few reserves for emergencies or investments. Pre-closure would be undesirable to lenders who could find it valuable to maintain cash reserves or invest in higher-paying investments.
Furthermore, all loans are not calculated equally in terms of interest. When the interest is front-loaded, that is, if one pays a hefty percentage during the initial years, pre-closing in the latter half of the tenure will not reap whopping benefits. Loan amortisation schedule clearly needs to be gone through by the borrowers before making an early settlement.
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When Pre-Closing a Loan Makes Sense
Pre-closure is advisable in most cases when the time left is considerable and the prepayment penalty is low or zero. Recipients of windfalls, like bonuses, tax refunds, or inheritances, can pre-close if they cannot find a better investment.
It also holds true when EMIs for the month are burning a hole in the pocket, and pre-closure of the loan can ease the money pressure. Those who are looking to take another loan, e.g., a home loan, might also use pre-closure to enhance their debt-to-income ratio, which means better terms on the next loan.
When It's Better to Continue with EMIs
If the prepayment penalty is steep, the economic advantage from pre-closure is lost. Borrowers are then better off continuing with regular EMIs. Likewise, if money can earn more elsewhere, like through investment, allowing the loan to continue while earning returns on such investments could be a wiser decision.
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Borrowers also need to go through their liquidity requirements. Applying emergency money towards prepaying a loan might expose them to monetary charges if there occurs some unexpected spending.
Pre-closure of a personal loan is economically beneficial in some cases, but the decision depends on factors like penalties, outstanding tenure, liquidity requirements, and alternative investment opportunities. Borrowers should consider the pros and cons deeply before acting upon it, and their decision should be based on their overall financial objectives.
