Repaying the loan early saves interest, but banks may charge prepayment penalty. There is no penalty on floating rate loans, but there may be on fixed rate loans. It is important to compare the interest savings and penalty before deciding.
Many of us take loan to buy a house, car, higher studies or for any sudden financial need. But sometimes our financial condition improves sooner than expected and we want to get rid of the debt as soon as possible by repaying a large part of the loan. Repaying the loan before the stipulated time reduces the total interest burden and also helps in getting relief from debt quickly. But before running to the bank with the extra money in hand, you should know some important things. Everyone knows that there is a penalty for late payment, but some financial institutions also charge fees for early repayment of the loan.
What is prepayment penalty?
The Reserve Bank has given clear instructions to banks and non-banking financial companies (NBFCs) that they cannot charge prepayment or foreclosure charges on loans with floating interest rates. This rule applies to all types of loans, irrespective of the purpose for which they are taken. However, banks can still impose prepayment penalty on loans with fixed interest rates.
As the name suggests, this is the penalty that banks charge when you repay your loan before the due date. If there is a prepayment clause in your loan agreement, then you will have to pay this penalty. You might be wondering why do they charge a penalty when the bank is getting their money back quickly? Actually, the main source of earning of banks is the interest received on loans. When you repay the loan early, the bank does not get the future interest. To compensate for this loss, some banks impose prepayment charges.
This charge may vary from bank to bank and is not necessarily applicable on every loan. This entirely depends on the terms of your loan agreement. Therefore, before signing the loan papers, read the conditions written in small print carefully.
How to know whether early repayment is beneficial or not?
If your bank is not charging any prepayment fee, you can save a huge amount by repaying the loan early. Even if there is a penalty, paying early may still be beneficial considering the interest savings and the remaining loan tenure.
For this, first of all calculate how much amount you will save in the form of interest by repaying the loan early. This is the amount you have to pay in the remaining tenure of the loan. Deduct prepayment penalty and other extra charges from this savings. Also see whether the penalty is a fixed amount or a percentage of the outstanding loan. The amount that remains after deducting all this is your real savings. If this value is in minus, it means that you will spend more in penalty than you save.
advantages
With less interest, more money is saved. Getting rid of debt quickly improves your credit score. You can invest the extra money in your hand somewhere else or spend it on your needs. The chances of getting a new loan at a lower interest rate increases. You do not have to pay charges like maintenance or processing.
Loss
Tax exemption is available on interest paid on business loan. This benefit may stop if you repay the loan early. Prepayment penalties are sometimes so high that your savings from early payment can be significantly reduced.