Car loan prepayment blues? Here's help

Lured by the heavy duty advertising for the lucrative financial instruments (highest NAV et al), I too thought of investing in these instruments and make big bucks for my future. So with all other EMIs and ECS payments in the pipeline, it looked difficult to take out funds for these schemes.

Immediately a thought crossed my mind. What if I close my 3-year (loan tenure 5 years) old car loan? Prepayment of the car loan will not only relieve me from doling out substantial chunk in the form of monthly installments but will also substantially improve my monthly cash flow.

After talking to my lender I realised that it should have been a well-planned decision beginning from the day I took my car loan.

So, in case any of you guys are planning to retire your car loan here is what you must know for making your task easier: beginning from what you should look at while taking a car loan.

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One of the first things you need to look at while taking a car loan is the monthly installment, popularly known as the EMI (equated monthly installment). While different banks would give you different quotes depending upon their rules and regulations, you must compare your monthly outflow for the same amount and for the same tenure.

Remember that the effective interest rate is a function of the reducing balance method being used to calculate it.

In this method the principal amount being repaid, is reduced from the outstanding loan amount. Every time you make a payment, the interest you pay is calculated on the balance outstanding principal.

Different banks can use different methods like daily, monthly and quarterly reducing methods on which the principal, on which you pay interest, reduces depending on the duration chosen by the bank.

Where as in yearly method, the principal is reduced finally, at the end of each year.

This effectively implies that though you have paid back a part of the loan during the year, the principal outstanding gets reduced only at the end of the year.

This simply means that the earlier the principal reduction is done, the lower the amount you will pay to the bank as interest.

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Now if you plan to exit from the car loan, here are few pointers: 

• Collect all details regarding your car loan, which can be found at your monthly loan statement.
• One important tip to pay off your car loan is to create a loan amortisation table in the spreadsheet programme of your computer.
• Enter and evaluate your latest loan information.
• Be equipped to talk to your bank.

However, while prepaying any kind of loan there is a prepayment charge.

The prepayment charge in case of most new generation private sector banks is around 4 to 5 per cent of the amount outstanding.

In case of public sector banks it is around 2 per cent.  Service tax, too, is applicable.

So if you decide to prepay at a time when your loan outstanding is Rs 3 lakh you would have to pay a prepayment charge of Rs 15,000 (5 per cent of Rs 3 lakh).

Nevertheless, even with the prepayment charge it makes sense to prepay.

If you were to do a fixed deposit of that amount you would get a maximum of 6 per cent after tax returns. If you use that amount to prepay, you lose the 6 per cent you would have got otherwise. But at the same time you would be not paying the 13 to 14 per cent that you are paying on the loan.

One of the main advantages of repaying your car loan ahead of time is that you get huge savings on the monthly interest. If you want to utilise your money where then it is certainly a good option.