What is a prepayment penalty and how to avoid one?

What is a prepayment penalty and how to avoid one?

Except for credit card bills, personal loans carry some of the highest interest rates as they are unsecured. Nevertheless, they are still a popular choice of financing for those in urgent need of cash.

Before choosing a personal loan, one needs to look for the lowest interest rate and prepayment penalty.

What is a prepayment penalty?

Prepayment refers to the full or partial settlement of debt before its official due date. Many financial institutions charge a specific fee for this facility called a prepayment penalty. Such a penalty encourages borrowers to repay their loan over the whole tenor, allowing financial institutions to collect the entire payable interest.

Borrowers can choose to prepay their entire loan amount in one go ahead of the due date or pay a part of their debt. Using this facility, they can bring down the outstanding principal, which reduces the payable interest and loan tenor. Borrowers can reduce their financial burden in the future using their extra cash to pay off loans partially.

Ways to make prepayments for personal loans

There are two ways one can prepay his/her personal loan:

  1. Part-prepayment

One can make a partial prepayment of his/her personal loan with a lump sum that does not equal the entire outstanding principal amount. With a partial prepayment, one can lower the unpaid principal amount, bringing down the EMIs.

It is an easy and effective way to save on the total payable interest, provided that the repayment amount is significant. Borrowers can make multiple such payments to bring down the EMI amount over time.

Small prepayments may not benefit the borrower when there is a prepayment penalty. Thus, people should check all the fees and charges applicable for the personal loans before choosing a lender.

  1. Full prepayment

Borrowers can also make a full prepayment or foreclose the loan by repaying the total outstanding amount in one go. A full prepayment early into the loan tenor can save a lot of money paid as interest. Borrowers can close their personal loans early to increase their credit scores. However, most financial institutions have a lock-in period following which one can prepay the outstanding amount.

How to avoid paying a prepayment penalty?

Different financial institutions charge a prepayment penalty ranging from 2% to 5% of the outstanding amount. This can vary depending on your remaining loan balance and for partial and full prepayment facilities.

The RBI has directed financial institutions to stop charging prepayment penalties on loans with floating interest rates. Many NBFCs offer personal loans on a fixed rate basis, so most borrowers may not benefit from this. However, some financial institutions do offer zero penalties for loan prepayment.

Before signing a personal loan agreement, borrowers must ensure to read the fine print on it. Take a note of the interest rates, additional charges, penalties, stamp duty and taxes before picking a loan provider.

If you opt for a loan with a prepayment penalty, remember to compute the additional charges using online calculators. Try to figure out how much the penalty will cost you compared to the interest saved from prepaying the loan. You should also consider investing your idle cash elsewhere in case you get better returns.

Benefits of prepaying personal loans

Given are some of the advantages of prepaying personal loans:

Become debt-free faster: Every borrower wants to be debt-free as soon as possible to avoid cash crunches. When they use surplus cash to repay part of their loan, they are free from the burden of future EMI payments.

Reduce the total payable interest: One can make a full prepayment to save a lot of money on the interest outgo. If the financial institution does not charge a prepayment penalty, one can make regular part prepayments to reduce the EMI burden.

Tax benefits: Self-employed individuals can get personal loan tax benefits for prepayment if the loan is used for business purposes. Personal loan tax exemption for salaried people applies if the loan amount is for purchasing and constructing a residential property or for certain investments.

Financial institutions provide pre-approved offers to simplify the loan application process. They offer this facility for products like personal loans and business loans. Individuals can check their pre-approved offers in just a few seconds by providing their contact information.

One should remember to keep these pointers in mind and check the prepayment penalty before opting for a personal loan. Because lower EMIs will allow you to repay your loan with ease.