Life is full of uncertainty, wherein one may face several situations warranting a need for extra money. Under such circumstances, a loan is considered a good option. When your financial situation gets better soon than anticipated, you may feel the need to repay the loan prior to the end of its tenure, so as to be debt-free as early as possible.
Also, lowering your debts can help you get a good credit score. To check your latest credit score for free try out Credit Mantri, the online loan analysis platform, which provides you with the latest credit score within a matter of a few minutes.
Repayment of your loans earlier than the loan term is a good option as it results in the reduction of total interest cost and ensuring your debt burden is considerably reduced. However, there are some hidden facts, which you need to carefully consider before applying to the lender for loan pre-payment.
For instance, are you aware that like a penalty raised for loan instalment default or late payment, banks similarly charge you for early repayment of loan? In this guide, we take a closer look at the loan repayment penalty and walk you through the benefits and drawbacks of foreclosing your loan.
What is the loan prepayment penalty?
A prepayment penalty refers to the penalty/charge imposed by the lender to the borrower when the latter opts for pre-payment of the loan before the end of the loan tenure as per the original loan agreement. When there is a prepayment clause as part of the terms and conditions in your loan agreement lenders will penalise you for repaying your debt before the end of the specified loan period.
This penalty is levied and is justifiable also if considered from the lender’s perspective. When you repay your loan earlier than the end of the actual loan term, then lenders tend to lose money on the potential interest portion of the remaining loan amount. This loan interest constitutes a major component of income for financial institutions. As such, most lenders have this prepayment penalty clause included as part of the original loan agreement.
So, be very careful when you undertake a loan and be aware of the prepayment penalty clause terms in the loan agreement before you sign it, so as to have any confusion when you want to prepay the loan at a later stage.
So, does that mean one should not repay their loans at an early tenure?
How to calculate the loan prepayment penalty?
There could be instances, where some lenders do not have a prepayment penalty clause as part of their loan agreement. In such cases, you tend to benefit if you repay the loan at the earliest saving money on interest cost. In most instances, the prepayment penalty clause is part of the loan agreement, but there is no need to despair. You can still save on interest charges but that would depend on your outstanding loan amount and the subsequent penalty levied.
The expected savings on prepayment of loan can be calculated by adding the total interest generated for the remaining loan period and any other charges. This total amounts to the expected savings you generate if you go in for early repayment of the loan in the present day. From this amount, you need to reduce the prepayment penalty and other fees, if any.
- If this net amount is positive, then you save by repaying your loan early.
- If the savings is a negative amount, it implies you are losing money by the early repayment of the loan.
Benefits and Drawbacks of Prepayment of Loan
Now that the prepayment penalty clause has been understood, let us look at the benefits and drawbacks of early loan repayment.
- Lower interest charge resulting in more savings
- Reducing the number of ongoing debts implies a better credit score improving your chances of getting future loans
- More money in hand which can be put for better use like investment or savings
- Can apply for a new loan at a better rate
- Reduction in fees on the loan account
- Tax benefit gets reduced as interest on business loans is eligible for deduction
- Prepayment penalty charges could entail a high amount
Should I go for loan prepayment?
Check the various options before going in for the early closure of the loan. The prepayment penalty is one of the most important elements of loan closure. Though clearing your loan would mean you are debt-free earlier than anticipated, it is necessary that you are aware of the charges that you have to pay while choosing a loan prepayment. Understanding all the terms and conditions before actually repaying your loan at an early tenure will save you all the headache and confusion when you actually apply for the loan closure.