Summary of this article
Early loan repayment may trigger costly prepayment penalties.
Partial or full prepayment affects interest savings differently.
Reviewing loan terms helps evaluate actual financial benefit.
Whenever borrowers have extra money, they initially desire to settle loans in advance. Though it might appear to be a good financial decision, settling debt prior to its maturity can, at times, be accompanied by additional expenses. Most lenders charge prepayment penalties to compensate for the interest earnings they forfeit when a borrower pays a loan in advance.
What Are Prepayment Penalties
A prepayment penalty is a fee charged whenever a borrower chooses to pay off part or all of a loan early, in accordance with an agreed schedule. The concept is straightforward: paying early costs the lender interest revenue they would have received over the shorted term. As payment, a charge is assessed on the amount outstanding.
Home loans and car loans permit prepayment after the lock-in period of 1-3 years with charges between 2-5 per cent of the outstanding amount. Personal loans are usually short-term in nature and generally accrue the same prepayment penalty as home and car loans.
For example, if a borrower owes a home loan of Rs 8 lakh and the penalty for prepayment is 3 per cent, the borrower would pay Rs 24,000 as a charge to repay the loan.
Why Lenders Charge These Fees
Lenders arrange long-term loans to get consistent interest revenue. Premature repayment interferes with this cash flow, and prepayment penalties safeguard lenders from loss of revenue precipitately. Fixed-rate loans are more likely to impose such penalties since lenders will not gain from interest rate fluctuations, while floating-rate loans may not impose fewer penalties after a specified time period.
How Prepayment Works
Borrowers can choose partial prepayment, a lump sum against the principal, or full prepayment, settling the entire loan. Partial prepayments save interest outgo in the long run, but timing is of the essence. Prepaying towards the end of the tenure may save a marginal amount of interest. Prepaying early will save more, but it will attract stiffer penalties, which will eat into the savings.
How It May Cost More
Suppose a borrower has taken a Rs 10 lakh personal loan at 10 per cent interest over five years. After two years, they decided to prepay the remaining Rs 6.6 lakh. Expected interest savings are around Rs 90,000. However, a 3 per cent prepayment penalty adds Rs 19,800, plus Rs 2,000-3,000 in processing charges. After accounting for these costs, the actual savings drop significantly. If the prepayment amount is invested elsewhere, the opportunity cost could also decrease the advantage.
Careful review of the loan agreement for penalty provisions, lock-in periods, and rules of calculation is also necessary.The borrower can request an amortisation schedule to see how payments are disbursed between interest and principal. This helps in evaluating whether prepayment actually saves money.
