Is Prepaying Your Personal Loan A Good Idea?

A personal loan is a saviour in many cases when one needs to quickly shore up resources for meeting some short-term expenses. It is processed swiftly, if the borrower meets all the criteria of the lender. In addition, a personal loan offers great flexibility of usage.

But a personal loan has other implications in terms of interest expense, how it affects one’s credit history and other issues. Since it is an unsecured loan product, lenders tend to evaluate loan applications closely along with the income profile and credit history of the borrower and tend to reduce the risk by charging a higher interest rate.

Borrowers, on the other hand, have the option to prepay and foreclose their personal loan account if they get some unexpected cash ahead of schedule or if their income increases.

Whether one should go ahead with prepayments would depend on the pros and cons.

Benefits Of Prepayment

• Lower Interest Outgo:

If we look at the benefits of prepaying the personal loan, the biggest advantage is that one doesn’t need to pay the interest expense that one would incur if they continue with the loan tenor. Since the personal loan is unsecured it carries much higher interest rates and it is advisable that borrowers retire such high-cost loans, if they have the wherewithal to do so.

• Debt Burden:

Another direct impact of a prepayment is that one’s total debt burden declines. This tends to reduce the mental stress related to meeting the equated monthly installments (EMI) outgo every month. At the back of the mind the burden of a debt as a liability tends to affect financial independence and reduces disposable income since part of the income goes to service the EMI. It tends to affect one’s health that one can mitigate by prepaying the loan.

• Credit Score:

An associated factor is that prepayment improves one’s credit score. Since personal loan is a form of unsecured loan it has a bigger negative impact on the credit score compared to collateral-backed loans such as an auto loan or a housing loan. Prepayment does not just reduce the debt burden and positively affects the credit score but also improves the debt mix as a liability of the borrower since the outstanding unsecured loan declines.

Disadvantages Of Prepayment

Loan prepayment is not a one-way street in terms of advantages. There are some adverse impacts that one needs to keep in mind.

• Lump-Sum Payment:

Since one is making a bigger than usual EMI payment on the outstanding loan, it results into a lump-sum outgo from the hands of the borrower.

• Foreclosure Charges:

Almost all types of loans come tagged with various additional charges and fees. One of these is prepayment charges or foreclosure fees. When a borrower repays the loan amount before the duration of the original loan tenure, it reduces the potential interest income that the lender could have earned. Lenders, therefore, add a prepayment penalty or a fee if the borrower prepays part or in full. This fee is higher if one prepays far too quickly and reduces as one approaches the end of the loan tenor.

If one has to decide on what to do with extra cash at hands when they have an outstanding personal loan, they need to weigh the pros and cons of the move. If the loan agreement does not have any prepayment clause or even if it is there the amount is nominal, one should opt for prepayment. In general, the advantages of a prepayment of a personal loan outweighs the disadvantages.

This may not be so for some other forms of loans such as a housing loan where one also gets tax concessions and deductions from the taxable income. In such cases one has to carefully calculate if the benefit of prepayment is actually more than the disadvantages. In the case of a personal loan, this is usually an easier choice.

Conclusion

A personal loan is a handy method to meet short-term cash needs. It is processed quickly and does not come attached with the headache of a collateral. However, this also tends to push higher the interest cost of such an unsecured loan. It is advisable that if the borrower has additional resources they should try and prepay the personal loan as it reduces the debt burden, improves credit score and also helps save money in terms of interest expense.

IIFL Finance offers personal loans up to Rs 5 lakh swiftly without any collateral with a digital application and approval process. IIFL Finance allows borrowers to repay the loans in easy monthly installments and, if they want, prepay their personal loans in part or full after paying a nominal fee.