Prepaying your personal loan? What you must know

Feeling burdened by the personal loan which you had taken to fulfill the desire of visiting foreign shores? Memories of which you still relish, but loan you want to perish. If not perish all together then at least prepaying your personal loan.

But before taking this step you must base your decision by keeping a few factors in mind.

The lenders making frantic calls to you for availing that personal loan -- which gave wings to your desires -- lured you, and you fell in a trap.

But seriously speaking personal loans are an effective tool to meet any financial emergencies or contingency requirements like medical situations, marriage, family function, education, vacations, travel, home purchase, home improvements etc.

The best part is that no security is needed but qualifying criteria is quite stringent as the risk involved is greater here. But banks are more than happy to entertain qualified individuals/ professionals which require minimal paperwork. While personal loans are cheaper than credit cards they are more expensive than home loans.

Before opting for a personal loan, you must be aware of the method of calculation of interest rates on such loans. This is very important to know in order to compare other options (interest rates) available to you. Personal loans usually come with either flat rate, reducing balance or advance equated monthly installment, EMI, (normally used for consumer durable loans).

Take the case of the flat rate; the interest charged is basically simple interest. So if you take a personal loan of Rs 2,00,000 at a flat rate of 15 per cent, your interest is going to be Rs 30,000 per year for the tenure of your loan.

In the case of reducing balance, the EMI and the interest computation is equated in EMIs over the tenure of the loan and then you are charged. The interest is charged on the balance outstanding. So effectively this means that between going for 10 per cent flat and 10 per cent reducing EMI method for the same tenure, the reducing balance is a cheaper option.

In advance EMI, lenders normally take two to three EMIs in advance thus effectively reducing your principal amount. Interest is charged on the entire amount instead of the reduced principal interest.

So basically, for a loan of Rs 2,00,000 with three advance EMIs of Rs 30,000 your loan may actually be for Rs 1,70,000 but you may be charged interest on the entire Rs 2,00,000.

Once you are aware of the method of calculation of interest for your personal loan, it will help you in weighing the various options available at the time of prepayment and you will be able to make a sound judgment on the prepayment of loan.

Now that you are considering prepayment, an important factor to consider is the penalty that you will have to pay while making early pay off of  your loan.

So if you have gone for a one-year, two-year, three-year or five-year personal loan and you decide to prepay the entire amount, then banks would charge you anywhere in the range of four per cent to 5 per cent penalty.

Reason being, at the time of taking loan lenders had quoted you a competitive rate based upon a set tenure they would not like to lose.

If you think that you have money available to you through other means and that the four per cent cost is something you are willing to incur, you can prepay the loan.

Also, when the bank offers you the option of prepayment it does not give the flexibility of part payment. If you decide to repay the loan earlier than the pre-determined period, you have to pay the whole outstanding principal. If you have a minimal surplus available to pay a part of your loan that would reduce your interest burden, but the bank does not allow it.

Finally, base your decision on the above-mentioned factors along with the interest rate scenario at the time of deciding to prepay. If interest rates have risen since the time you have taken your personal loan, it would make sense to continue with the loan.

However, if interest rates have fallen since you have taken personal loan it may be worth considering taking another personal loan (with reduced interest rate) in order to pay off the more expensive loan. Subject to the condition that the bank allows you to do so.

But it is advisable to take into account the various costs -- processing fees of new loan, cost of foreclosure of old loan, etc -- involved.

And if you feel that prepayment is still the cheaper option, go ahead unburden yourself!