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What is a loan prepayment and how does it work?

What is a loan prepayment and how does it work?

Many people are looking for different ways to reduce or consolidate their debt. One of the most popular methods of borrowing is to repay partially or in full before the full term of the loan. This can reduce your debt, which can also lead to huge savings, otherwise you can pay in the form of interest.

To make this possible many banks are now offering pre-payment facility. Let's see what is a loan prepayment and how it works.

What does it mean to repay a loan in advance?
As the name suggests, pre-payment is a facility offered by some banks that helps the borrower repay the loan before their actual repayment period according to the loan documents. Advance payments can be made in parts or in full.

What is a loan prepayment and how does it work?

How does a loan prepayment work?
To understand this, let's look at the following example of a home loan taken by Mr. X from his preferred bank.

Loan particulars Loan details
Loan amount        20,00,000
Interest rate        9%
Tenure               20 years
EMI                      17,995
Total interest amount (in 20 years) 23,18,687
Total amount payable (in 20 years) 43,18,687
Now, let’s assume he chooses to pre-pay the loan in the 11th year.

Prepayment particulars Amount
Opening balance (principal) 14,20,518
Prepayment amount         14,20,518
Interest amount saved         7,38,825
The method of prepayment depends on whether you are going for part-prepaid or full-prepaid. With part-prepayment, you have to pay a fixed amount over the entire loan amount. As you can see in the example above, by paying the balance (principal) amount in full after 10 years, Mr. X.

And, if Mr. X chooses to increase the EMI to Rs 5,000 per month from the 11th year, what will it be like?

Prepayment particulars   Amount
Opening balance (principal)   14,20,518
Prepayment amount monthly   5,000
Total EMI (17,995+5,000)   22,995
Interest saved                           2,44,067
Tenure reduced (in months)   36
Just by increasing EMI by Rs 5,000, Mr X was able to reduce the tenure by up to 3 years resulting in total interest savings of Rs 2,44,067.

Benefits of loan prepayment

Now you know how loan prepayment works; Let us know about some of its benefits.

Any down payment for the loan is not interest unless it goes directly to the principal.
Loan prepayment can help you consolidate your debt.
Substantial savings on interest.
Advance payment with multiple loans
Borrowers with multiple loans can use the prepayment facility to consolidate their loans. Most importantly, pre-payment loans can be used to switch from high interest rate loans such as personal loans to low interest rate options such as home loans against real estate. Check the loan, various loan options and evaluate accordingly.

Things to keep in mind before repaying a loan

Although prepayment is considered very beneficial, there are some things every borrower should know.

Prepayment Lock-in Period: Most banks have a lock-in period of 1 to 3 years, during which time you are not allowed to repay the loan in advance. However, there is no lock-in for floating rate loans as per RBI guidelines.
Advance Payment Penalty: Penalty may be imposed for early repayment of the loan before the end of the lock-in period (for floating rate loans and business loans). Check if this penalty exceeds the savings on interest.

Loan interest rate: Most banks calculate the interest fraction of the loan on the method of reducing the balance. This means that initially the interest portion is higher and the tenure is shorter. A loan pre-payment calculator can help you find out the exact interest you can save by following a pre-payment plan.

Pre-pay or pre-pay?

The decision between the two depends on many factors such as loan type, interest rate, down payment penalty, loan tenure and more. Also, pre-payment terms vary between banks. So, make sure you check with your bank before signing the loan agreement.

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