Personal Loan Prepayment: Is it a good idea to repay a personal loan early? Understand when it is beneficial..

Personal Loan Prepayment: When taking out a personal loan, most people focus solely on the EMI. However, a few months later—perhaps upon receiving a bonus or accumulating savings—the question arises: should the loan be repaid early?

There is no one-size-fits-all answer. Sometimes, prepayment can save lakhs of rupees in interest, while at other times, the benefit is minimal. Therefore, it is important to understand a few key factors before making a decision.

When is the benefit greatest?

In the initial stages of a personal loan, the interest component of the EMI is higher. Over time, the interest portion decreases while the principal component increases.

This means that prepaying early in the loan tenure allows you to save more on interest. If you repay the loan during the final year, the savings are significantly lower.

Let’s look at an example.

Suppose you take a personal loan of ₹5 lakh for 5 years at an annual interest rate of 15%. The EMI would be approximately ₹11,895. Over the full 5-year period, the total repayment would be around ₹7.14 lakh, meaning you would pay about ₹2.14 lakh in interest alone.

Now, suppose you make a prepayment of ₹2 lakh after 12 months. In this scenario, the remaining interest payable could be reduced by thousands of rupees. If the bank charges a low prepayment fee, this decision could prove to be quite beneficial.

Consider it seriously if the interest rate is high.

Personal loan interest rates typically range from 10% to 24%, which is significantly higher than home loan rates. If your loan carries an interest rate of 14%, 15%, or 16%, repaying it early can lead to substantial savings. However, if you secured the loan at a lower rate through a specific company scheme or offer, be sure to run the numbers first.

Check for prepayment charges.

Most banks and NBFCs levy foreclosure or prepayment charges ranging from 2% to 5% for closing a loan early. Many banks also do not permit prepayment during the first 6 or 12 months of the loan tenure. Therefore, first check whether the savings on interest exceed the prepayment charges.

Do not use up all your savings for the loan.

Suppose you have savings of ₹3 lakh and you use the entire amount to repay the loan. If a medical emergency requiring ₹2 lakh arises a month later, you might be forced to take out a new loan or use a credit card. Hence, even after repaying the loan, ensure you retain an amount equivalent to at least 3 to 6 months' worth of expenses as an emergency fund.

Clear your personal loan before taking a home loan

If you plan to take a home loan in the near future, paying off your personal loan first can be advantageous. This improves your Debt-to-Income (DTI) ratio. Banks consider your total EMI obligations; a lower EMI can increase your chances of getting a new loan approved.

When is prepayment unnecessary?

If your loan is in its final year, there is no need to rush. By that stage, the majority of the interest has already been paid. Similarly, if you have an investment opportunity offering a potential 15% return while your loan carries an 11% interest rate, investing first might be the wiser choice. However, do consider the associated risks.

What should your decision be?

Prepaying a personal loan is most beneficial when the loan is in its early stages, the interest rate is high, and prepayment charges are low. However, exhausting all your savings solely to clear the debt is not advisable. Calculate the figures first, then make your decision. Sometimes, waiting a little longer can prove to be more beneficial for 

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