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Rediff.com  » Getahead » The benefit of prepaying a loan

The benefit of prepaying a loan

By Joseph Samson
October 18, 2015 13:00 IST
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However, opportunity costs should be kept in mind by the borrower while taking any such decision.

Based upon requirement of an individual loans can be classified into various categories. Loans can be differentiated into educational loans, home loans, vehicle loans, personal loans, gold loans etc, catering to the various needs of a person at different times while acquiring an asset.

Interest rates on loans can also be differentiated into fixed interest rates or floating rates. But there is one thing which comes tagged along with all loans and that happens to be the 'terms and conditions' or the contract of the loan. Terms and conditions safeguard the interests of both the borrower as well as the lender.

The terms and conditions of a loan cover all the aspects related to the loan, right from applying for the loan to margin amount, loan tenure, moratorium period, penalties, surcharges, documentation and many more. But one of the major clauses in most loans is the 'prepayment' clause. Prepayment means repayment of a loan by the borrower before the stipulated time in the loan contract.

What is prepayment?

Prepayment as the word suggests refers to repayment of a loan before its stipulated tenure. Prepayment of loan involves simply contributing an extra sum towards EMIs. This extra amount reduces the overall tenure of the loan, which also reduces the total interest paid and hence total amount paid to the bank is reduced.

Banks generally discourage borrowers to prepay fixed rate loans because in case of prepayment/foreclosure, the borrower ends up paying lesser to the lender than it would have been under the full tenure of the loan. The lender generally charges a penalty on early closure of such loans.

Pros and cons of prepayment of loans

Banks levy 2-3 per cent of prepayment penalty on balance amount. This is because, the bank bank's profit on a loan is the interest component. Larger the repayment tenure, higher would be the interest earned by the bank. Therefore reduction in the time frame of the loan, reduces the interest the borrower pays to the bank, thereby reducing the profitability of the bank.

Some banks however, allow the customer to prepay the loan up to a certain amount without any fine, whereas some banks like State Bank of India, do not charge any penalty at all on prepaid loans, if the payments are made out of own funds.

Recent announcement of Reserve Bank of India prohibits banks from charging foreclosure penalty on home loans. State Bank of India already leads the pack in stopping foreclosure penalty on both fixed and floating rates home loans.

However there are certain benefits linked to prepayment. Prepayment of loan can be used to avail tax rebate u/s Section 80C. Other benefits include reduction of the tenure of the loan and also in reduction of the rate of interest charged.

The benefit of prepayment explained

Let us consider a Rs 40,00,000 home loan with 13 per cent interest rate and a tenure of 25 years. Also assume, 5 years of the tenure has passed, and the remaining time is 20 years. We calculated the EMI for the loan using Rupeetimes EMI Calculator, the EMI for the loan comes to Rs 45,113.

Normal loan payment:

If the borrower continues to service his/her loan as per the terms of the loan, s/he stands to pay:

Total Interest: Rs 69,76,558

Total Principal: Rs 38,50,661

Total sum = Rs 1,08,27,219 (Rs 1.08 crore)

Prepayment:

If the borrower starts paying 1 additional EMI per year, i.e Rs 45,113 distributed evenly across existing EMIs, his/her resultant EMI comes to Rs 48,873, in that case:

Total Interest paid: Rs 48,42,540

Total Principal Paid: Rs 38,50,661

Total Sum = Rs 86,93,201

The above figures were calculated using amortisation tables available with the loan contract, and can be arrived at for any loan.

Total benefit

If the borrower pays off the loan in the 14th year then by increasing just one EMI per year, s/he would have saved 6 years of repayment tenure along with Rs 21,34,018 which is a large sum. Even if the bank charges a penalty of 2-3 per cent on the balance amount, the borrower stands to pay an extra Rs 64,020. Even after which s/he stands to save about Rs 20,70,000.

Decision

Opportunity costs should be kept in mind by the borrower while taking any such decision. If one can find an investment avenue which offers higher rate of return (example ELSS) than the interest rate of the loan, it is advisable to consider investing in that security, but such investments are bound to be risky compared to risk-free returns on prepayment.

Illustration: Uttam Ghosh/Rediff.com

 

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Joseph Samson