Whether you want to own your dream house, purchase a car or send your child abroad for higher studies, there is a loan to fulfill every need. However, while servicing the loan, many borrowers think of prepaying their loan whenever they have surplus funds. Before you hurry onto this decision of utilizing these funds for prepayment, consider the following tips:
Make sure your emergency fund isn’t affected:
Avoid disturbing your emergency fund to prepay your current loan. Given that the main motive behind emergency fund is to help in tackling financial emergencies such as job loss, accident or severe illness, it shouldn’t be used for any other purpose. While planning to prepay and fixing the amount that you intend to prepay, ensure that you are left with enough savings to maintain liquidity in your finances. Additionally, continue maintaining emergency fund amounting to at least 3-6 times your monthly expenses.
Evaluate the opportunity cost of not investing:
Ability to prepay loan implies that you have surplus funds as a result of an investment getting matured, receiving bonus or promotion etc. But, apart from prepayment, these funds can also be invested in investment avenues such as mutual funds or fixed deposits, which would help in achieving your financial goal in future. So, before you decide to prepay loan, evaluate the opportunity cost of not investing by calculating expected returns on investment which you may have to forgo if you choose to prepay loan instead.
In case the interest amount being saved through prepayment is higher than the returns forgone by not investing, then you may utilize your surplus funds by prepaying the loan.
Consider other loans to be repaid:
Prepay loan with higher interest rate first, if you have multiple loans. Let’s assume that you are currently serving two loans – personal loan of Rs.10 lakh at 14% interest rate, and car loan of Rs.10 lakh at 11% interest rate. Both have tenure of 5 years. EMIs of personal and car loan are Rs.23268 and Rs.21742 respectively. When you prepay Rs. 5 lakh in lump sum, the EMI of personal loan drops to Rs.11634 and that of car loan comes down to Rs.10871 per month. So, total EMI savings for personal loan would be Rs.6, 98,048 and that of car loan would be Rs.6, 52,273. Hence, you should consider paying off personal loan first in this scenario.
Similarly, if the returns being earned on current investments are higher than the cost of your most expensive loan, then it would be better to continue with your investment, instead of prepaying your loan.
Beware of prepayment charges involved:
Lenders generally levy prepayment fee on borrowers, which should be taken into account while considering loan prepayment option. Due to RBI’s restrictions, floating rate loans does not involve any prepayment penalty, but lenders do charge prepayment penalty in case of fixed rate loans. Hence, make sure you take into consideration prepayment charges, if any, which are levied by your lender. Ignoring this may offset your savings on interest payment.
Prepay as early as you can:
The earlier you prepay your loan, the more interest you get to save. So, if you are planning to prepay, try doing so in the early stages of the loan, since it would allow greater savings on the total interest payout as compared to those at the later end of tenure. However, that doesn’t imply that you shouldn’t prepay during the later stages of loan tenure. Prepaying during early stages of tenure enables the borrower to save more interest and also reduce the loan tenure.
– Naveen Kukreja – CEO& Co-founder, Paisabazaar.com
