Banking: What is the loss to the bank if the loan is repaid before time? Why do banks charge prepayment penalty?

Nowadays, many types of loans like home loans, car loans, or personal loans are available from the bank. If you take a loan, then it has to be repaid within a fixed period. For this, EMI has to be paid every month. After a while, EMI becomes a burden, in such a situation the borrower wants to get rid of this loan as soon as possible. The way to close the loan before time is prepayment.

Whenever a person gets a lump sum amount from somewhere, he thinks of closing it by prepaying the loan. Through prepayment, you can either reduce the principal amount by paying a part of the loan, or you can close the loan by paying the entire amount in one go. If you return the entire amount to the bank, then the account between you and the bank is over, then why do banks levy a penalty on prepayment? Have you ever thought about this?

Know why banks charge a loan prepayment penalty.
When you repay your loan by prepayment, you feel that you are doing a good thing, but from the bank's point of view, it is a huge loss for it. The calculation of how much interest will be charged on the loan depends on the loan tenure of the borrower, and the EMI is prepared accordingly. But if you choose the option of prepayment in the middle of the tenure, then the bank is not able to charge you the interest that it could have charged in your entire tenure. In such a situation, the bank suffers a huge loss because banks earn a lot from the interest on the loan. To make up for this loss, banks charge loan prepayment penalty on the borrower. The matter of prepayment penalty is included in the terms of the loan. Some lenders charge a fixed penalty, while some charge on a percentage basis. Therefore, whenever you take a loan, understand its terms well.

Prepayment charges are not levied on all loans.
Prepayment charges are not levied on all types of loans. If you take a home loan at a fixed rate, then the bank can charge you a prepayment charge on its prepayment. However, prepayment charges are not levied on floating-rate loans. On the other hand, if you repay your loan on time, then most banks charge a prepayment charge on this too. The terms and conditions of banks are different regarding this.

Do this calculation before deciding on prepayment.
To understand whether the decision of loan prepayment is beneficial for you or not, first see whether the prepayment penalty is mentioned in the terms and conditions of the loan or not. If not, then you can take this decision. On the other hand, if a prepayment penalty is being charged on the loan, then you should do a calculation. Only after this, conclude.

First, see how much penalty will be charged for repaying the loan early. After this, calculate the total interest to be paid on your remaining loan. After this, subtract the penalty from the interest. After this, decide according to the answer you get. If you are getting a good amount of savings in interest even after paying the penalty, then you can decide to repay the loan. If the matter is equal, then the only benefit of loan prepayment is that you can get rid of EMI. Decide after looking at your situation. On the other hand, if you feel that the answer is negative, then you will only suffer a loss due to prepayment, in such a situation it will be wise to repay the loan in its entire tenure.

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