INVEST SMART - The Economic Times (2024)

By Rishi Mehra

Barring interest charges on the unpaid amount on your credit card, personal loans attract some of the highest rates of interest. Often ranging between 15 to over 20 percent, personal loans command a premium since they are often unsecured in nature. A personal loan, however, is popular in the country as it helps get over a temporary or an urgent need of cash. Often used to buy consumer durables, weddings, health treatment or even vacation, personal loans are offered by most banks in the country with some variations in charges and fees. However, if a personal loan can be prepaid or paid partly, there are certain advantages in store for the customer.

Full Prepayment:

Firstly, if the prepayment in full can be done relatively early into the tenure of the loan, a customer tends to save a lot on the interest. A personal loan generally has a lock in of about one year after which the entire outstanding amount can be prepaid.

For example, if the personal loan is for Rs. 2 lakh at an interest rate of 15% and for a term of five years, the monthly EMI comes to Rs. 4758. At the end of the first year the customer would have paid Rs. 29,039 towards premium and Rs. 28,057 as interest. If the customer decided to prepay the full amount now, he would stand to pay Rs.57,422 less in the form of interest.

Another example of this would be in case you take a loan of Rs. 3 lakh for a term of 5 years @ 15% ,you will have to pay an extra interest of Rs. 1,28,219. A breakup will show that first year you end up paying Rs. 42,086 or about 33% of your total interest, the second year you pay Rs. 35,084 or 27% of your total interest amount, while you pay Rs. 26,956 for your third year or 21%, Rs. 17,522 or 14% in the fourth year and Rs. 6571 or only 5% in the final year.

The trick clearly is to prepay the entire amount early in the tenure of the loan so that one can enjoy the advantages of foregoing less on interest. However, even at a later stage in the tenure where the customer may have paid much of the interest, if he does have some excess cash it is always better to prepay the loan and get the monkey off your back.

Some banks, however, do have penalty rates ranging from 3-5 % when a customer decided to prepay a loan. The Reserve Bank of India had recently directed banks to stop charging customers when pre-closing a loan account, but this only applies to loans taken on a 'floating rate' basis. Since most personal loans are on a fixed rate basis, the rule does not apply. There are, however, some public and private sector banks that do not charge anything prepayment. In this case there is a great advantage in making use of idle cash a customer may have by prepaying a loan. It is simple economics at play - if the idle cash in hand earns you less return when kept in a bank or invested elsewhere when compared to the interest you pay on your personal loan, it is wiser to pay off the loan.

Part Payment:

Part payment of a personal loan happens when you have a lump sum amount of idle money, but is not equivalent to the entire principal outstanding loan amount. Part payment works because it brings down the principal amount unpaid, which in turn brings down your EMIs and the total interest you pay. However, it is important to keep in mind that only when you make a significant amount of lumsum money as part payment, does it help.

This is an easy but an effective way to save down on your interest amount as the part-payment amount directly gets deducted from your Principal Outstanding as on date/month of making the partial payment. In case you go for a Rs. 3 lakh loan for a term of 5 years at 15%, you will have to pay an extra interest of 1, 28,219 (as illustrated above). In case you make a nominal partial payment of Rs. 50,000/- after 6th EMI you will be able to save 32% of your Interest portion.

There is a direct relation to the amount you part-payment and the time you do it to the savings you can have from minimizing your interest outgo. However, making a very small part payment for your personal loan does not help, especially if there are prepayment charges.

There is another advantage of part payment. A part payment of a personal loan need not be only once. It can be more than once and can even be a regular payment of a lump-sum amount. This will again go towards bringing down EMI amounts and also the total interest paid. Even if there are prepayment charges for every transaction, if a substantial amount is paid back regularly, the benefits of a reduction in total interest paid will be much more. However, the big caveat in part payment is that many banks do not allow it when it comes to personal loans. Banks/NBFCs have a lock-in period on the term (Min. 6 to 12 EMIs) and the amount of part payment (either the Multiple of EMI or % of Principal Outstanding).

Effect on credit rating:

Prepayment of an ongoing personal loan does not have an immediate effect on your credit rating, but in the long run a full prepayment effectively is successfully closing a loan account, which does shore up your credit rating. On the other hand, part payment of a loan has no effect on your credit rating barring the fact that it reduces your total loan burden, which in turn should help you to pay off the loan completely in the stated tenure.

An old adage says one should borrow as little as possible and repay as quickly as possible. This holds particularly true for personal loans, which with their high rate of interest can be a big rip off. If you can prepay or part pay a loan, it's best to go for it without thinking much.

(Author is cofounder deal4loans.com. www.deal4loans.com is a platform for online comparison for retail loans in India. Views expressed are personal.)