Prepayment on personal loans is an important area all borrowers must consider before getting there personal loan.
Prepayment as the name suggests is a banking feature allowing you to pay your loan before the due date of the loan. For example, you decide to take a loan for 5 years at 16% interest rate from ABC Bank. Now, during the 3rd year of the loan, you have a sudden increase in income which allows you to pay your loan way before the due date. You decide to pay the full loan amount by the end of year 3. To do so you will have to follow your loan’s terms & agreements which dictate the option to do so and the corresponding costs.
The cost of borrowing is always higher to a customer than the cost of lending. For example, you can borrow at 15%, but you can save at only 9-10% per annum. If you have additional money which you plan to save, you will be earning only 10% on the savings. Whereas, you will be paying 15% on your pending loan amount. If you have the option to prepay, you can pay the loan amount instantly and save the additional cost of 5-6% on interest every year.
A bank borrows money at a lower cost and lends it at a higher price. Once they lend money, they earn the difference for the period of the loan tenure. If the customer decides to pay the loan earlier, the interest they would have earner over the additional period reduces. To compensate for this loss of potential revenue, some banks charge prepayment fees.
Prepayment charges have multiple restrictions and the rates vary significantly among banks. They are usually around 4-5% on the pending loan amount. Also, prepayment charges vary based on the passed loan tenure. Some banks offer 0 prepayment charges after 3 years, or some offer reduced rates after certain time period.
You should not simply go after low prepayment charges. First, among the available options see the various prepayment charges against interest rates. If you are getting low prepayment charges, but the interest rate is higher then you might want to still go for the lower interest loan offering. You can calculate this using a prepayment calculator to monetize the potential benefit of low prepayment fees.
More importantly, you should assess the probability of you prepaying the loan. Prepayment heavily depends on your financials. If you are expecting any significant increase in earnings then it makes sense for looking deeply into prepayment fees. Otherwise, simply go for lower interest rates.