The Impact Of Prepayment Penalties On Personal Loans

Personal loans have gained popularity in India. People take personal loans from banks and non-banking finance companies not just to meet emergency expenses but also for planned expenditures like marriage, annual family vacation, to fund business needs, etc. 

One of the reasons for the popularity of personal loans is the easy availability from banks and lenders like IIFL Finance. Lenders also do not ask for any collateral against the loan, unlike say in home or vehicle loans. However, because personal loans are unsecured in nature, they carry higher interest rates compared to other loan products. If the applicant is also not from the top category of credit scores, the interest rate could be even higher. The monthly repayment or the EMI is also higher because of the interest cost. EMI also depends on the repayment tenure, which usually range between three to five years.  For personal loans with smaller amounts, the repayment tenure could be even lower than three years. Borrowers also have the option to pay off the outstanding loan amount before the due date. This is called prepayment of personal loans.

What Is Prepayment?

Prepayment is when you repay a personal loan, either entirely or partly, before the end of the scheduled repayment cycle or the last EMI. This can be done by borrowers when they receive a decent sum of money, may be in the form of incentives or bonus salary or gift from family members. Prepaying a personal loan even partly can significantly reduce your monthly debt burden because personal loans carry high interest rates. Typically, lenders have a lock-in period of three months to one year from loan disbursement date. During this period prepayment is not allowed. Basically, only after timely repayment of a certain number of EMIs, prepayment or foreclosure of loans is allowed. Once the specified lock-in period ends, borrowers can go ahead with prepayment. The early you prepay, the more you save on the interest cost. However, lenders levy a prepayment penalty or foreclosure charges.

Prepayment Penalty

Lenders charge a prepayment penalty, which usually range between 4-5% of the outstanding principal amount. Before opting for a personal loan, always read the terms and conditions, especially with regard to prepayment penalties and foreclosure charges. But why is this penalty levied? Lenders borrow money, which is deposits in case of banks, and then give it as loans. The cost of borrowing money or payment to depositors is lower as compared to interest rate charged on loans by lenders. This is how lenders make money. Now, for every loan given by the lenders, there is fixed tenure, which gives a projection on the expected interest income. In case of prepayment of loans, lenders stand to lose on the interest earnings. Hence, to make up for some of these losses, a prepayment penalty is charged on borrowers. It is important to note that the Reserve Bank of India does not allow lenders to charge a prepayment penalty on personal loans availed on floating interest rate. However, there is no such restriction on personal loans opted for a fixed rate.

Before considering prepayment of personal loans, evaluate some of the key factors -

Saving On Interest –

Since interest rates on personal loans are higher, prepayment allows borrowers to save up on the interest that otherwise would have been paid over the term of the loan. However, borrowers must take into consideration prepayment penalty and other conditions, to understand what the net savings because of the prepayment is. Borrowers can use online calculators like the one provided by IIFL Finance to ascertain the savings by entering required inputs. Most borrowers think that prepayment is advisable only in the early loans of the loan tenure. However, if there is a sum of extra cash available, borrowers can go ahead with prepayment even in later years.

Increase EMI Affordability -

One of the important factors considered by lenders while assessing loan application is the monthly income. Usually, they prefer lending to borrowers whose total EMIs across various loans are within 50-60% of net monthly income (NMI). Borrowers breaching this limit may not get additional loans. However, prepayment of personal loans can improve your eligibility criteria as it reduces the EMI/NMI ratio within the bracket of 50-60%.

Improve Credit Score –

Credit bureaus consider the share of secured and unsecured loans while assigning a credit score. Higher score is assigned to individuals that have a higher share of secured loans like home and vehicle loans. Personal loans are unsecured in nature and prepayment may reduce the share of unsecured loans. A good score improves your eligibility for getting new loans and also allows you to bargain for lower interest costs.

Restriction On Spending –

While there are many benefits of prepaying personal loans, there are also some disadvantages, especially if not planned well. Since prepayment of personal loan, especially when it is full prepayment, a large sum of money is required. If it is not budgeted, it could restrict your spending ability for some time. While this may not be an issue if the spending is on leisure such as dining or going for movies, it could become a problem if any emergency crops up. Borrowers who are planning to prepay personal loans must ensure that they have an emergency corpus in case of any medical emergency or any other expense that can’t be postponed.

Conclusion

Easy availability and flexible repayment terms have made personal loans popular. Lenders like IIFL Finance have made the entire process, right from applying for personal loans till the time of disbursement, online and hassle free, eliminating paperwork. Loans from IIFL can be availed within short time of the application being approved and can be repaid in easy installments.