What is Loan Prepayment, and How Does it Work? 

August 22, 2022 . Home loans . 10 min read

There are a lot of people who are looking for various strategies to either cut down on their debt or consolidate it. One of the very well-liked strategies among borrowers is to return the loan, either in part or in whole, before the end of the loan’s lifespan. In addition to reducing your debt, consolidating it may save you substantial money in interest payments. The ability to make prepayments is currently offered by a number of institutions, which makes this possibility more widespread. Let’s look at what exactly ‘loan prepayment’ is and how it works. 

What is Loan Prepayment? 

To make a one-time, large payment toward the principal balance of a loan prior to the conclusion of the loan’s term is known as loan prepayment. Because a longer loan duration results in an increase in the total amount of interest paid, making a prepayment may be an efficient approach to lower your interest payments and, as a result, your overall debt load. 

A shorter loan term or a lower EMI payment are two common outcomes of early loan repayment. Either way, you’ll save a lot of cash on your monthly loan payments owing to this strategy. However, before choosing to prepay your loan, you need to be aware of the prepayment fees you’ll be required to pay to determine whether this choice is feasible.  

Prepayment considerations when taking out a loan 

Even though it is common knowledge that paying off a loan early may result in significant savings, there are still a few things that every borrower needs to be aware of. 

• Prepayment lock-in duration 

During the lock-in duration, which may range from one to three years and is imposed by the majority of banks, you are not permitted to prepay the loans. According to RBI standards, there are no lock-ins on floating-rate loans. 

• Prepayment penalty 

If you pay off your loan early, you may be subject to a penalty. Do the math to see whether the fine will outweigh the interest savings. 

• The interest rate of the loan 

Most banks use the declining balance approach to figure out the loan’s interest. Thus, interest accrual is greater in the beginning and diminishes in proportion to the length of the loan. Using a prepayment calculator or an excel sheet, you can figure out exactly how much interest you’ll save if you stick to your prepayment schedule. 

Benefits of loan prepayment  

It may be in your best interest to prepay your loan, since doing so might bring you a number of perks, including the following: 

• You’ll save a lot of money on interest 

In the event that you choose to make a complete prepayment of the whole loan amount, you will often be able to cut down significantly on the amount of interest that you are required to pay. 

Consider a 20-year, Rs. 50 lakh loan with a 9 percent annual interest rate and 240 monthly instalments. This works out to a monthly payment of Rs. 44,986. Let’s say you decide to make a prepayment of Rs. 50,000 just before the first instalment. Consequently, the remaining term of the loan will be about six months shorter. Over the course of the payback term, this implies that you may save nearly Rs. 2.4 lakh, which is almost five times the amount of principal returned. 

• Improves credit score 

A flawless credit report together with a clean record of loan payback is more desired, and lenders also like to provide loans to individuals who have credit histories like these. It is regarded as beneficial and will assist to boost your credit score. An increase in your credit score makes it easier to finalise your next loan request and also gives you more leverage to negotiate more favourable conditions with the lender. 

• Reduced financial stress 

Being debt-free comes with its own set of benefits. Your life will become less stressful, and you will be able to achieve financial independence sooner. Since the likelihood of a financial collapse will be reduced, and you will have more money available for spending. 

• Tax deduction under Section 80C 

It is also possible to make a claim for a tax deduction related to the loan prepayment under the provisions of the Income Tax Act’s Section 80C. This benefit is provided for any and all principal that is repaid during a given calendar year, along with any prepayments that may be made. 

Prepayment with various loans 

Borrowers who have various loans might utilise the prepayment option to combine their debt and make their payments more manageable. Most notably, a prepayment loan may be used to shift from loans with high-interest rates, such as private loans, to loans with lower interest rates, such as housing loans, mortgage loans, and other similar possibilities. 

How does a prepayment calculator work? 

You may assess whether or not to select the prepayment option on your loan with the help of a prepayment calculator, which is a tool that can be accessed online. When you try to prepay your loan, the majority of calculators found online will assist you in determining four important aspects of the loan: 

• Payable EMI sum 
• Modified EMI sum 
• Revised loan duration 

• Amount/percentage of EMI savings 

You will then be able to calculate how much money you would be able to save as well as the new amount of your EMI payments. Calculating otherwise may be difficult and time-consuming; however, using an online calculator is quite straightforward and simple. All that is required of you is to input the following information on the loan: 

• Pending loan amount  

• Loan duration  
• Interest rate  
• Prepayment amount  

After entering the pertinent information, you will be able to determine the total amount of money you would save by opting for the loan prepayment route. 

Conclusion 

It’s possible that prepaying your loan early isn’t always the smart move. If you’re thinking of prepaying your loan, you should only do so if the long-term advantages outweigh the penalty that will need to be paid. It’s possible that you may save a significant amount of money on interest if you carefully plan out your prepayment. 

Thinking about buying a home? 

Is your brain now chanting prepayment on a loop? Put your brain’s chant on hold. You can get to it after you select your dream home and have the down payment handy. HomeCapital makes it easier for you to purchase your first home by covering up to fifty percent of the amount of the down payment. Get your eligibility and an in-principle sanction letter from HomeCapital in just one minute and begin the process toward becoming a homeowner today.