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You have received a lump sum amount of money from a sudden bonus, incentive, or any other source, and your first wish is to get rid of the burden of a personal loan from your head. But then you remember that the bank will levy a prepayment penalty or foreclosure charge on closing the loan before the time. Now you are wondering whether paying a penalty to close the loan is a profitable deal, or if it is better to let the EMI continue?

This is a question that comes to the mind of almost every person taking a personal loan. The answer to this is not always 'yes' or 'no'. This is a decision for which it is very important to do calculations in every way. Let's end this dilemma and understand the complete calculation in simple language.

Why do banks levy a prepayment penalty?

First of all, it is important to understand why banks levy a prepayment penalty. When a bank gives you a loan, it expects to earn interest from you during the entire loan tenure. This is their business model. When you repay the loan before the time, the bank loses the interest it would have received in the future. To compensate for this loss, banks charge you a fee in the form of a prepayment penalty.

Usually, this penalty can range from 1% to 5% on your outstanding principal amount. Many banks also have a 'lock-in period' (eg, 6 to 12 months), before which you cannot close the loan.

How to decide? Understand the complete calculation here
There is only one way to make a decision - comparison. You have to see how much interest you are saving and how much penalty you are paying for it. If the savings are more than the penalty, then it is a profitable deal.

Understand with an example.
Suppose Riya has taken a personal loan of ₹ 5 lakh at an interest rate of 14% for 5 years (60 months).

Loan amount: ₹5,00,000
Interest rate: 14% per annum
Tenure: 5 years (60 months)
Monthly EMI (approx.): ₹11,634
Prepayment penalty (assume): 4% on outstanding principal
Riya wants to close the loan after paying EMIs for 2 years (24 months).

Step 1: Find out the interest savings
First, we need to find out how much interest Riya will pay in the next 3 years (36 months) if she does not close the loan.

After paying 24 EMIs, Riya's outstanding principal will be approximately ₹3,35,000 (you can check this from your bank statement).
How much Riya will pay in the next 36 months = 36 months x ₹11,634 (EMI) = ₹4,18,824.

Total interest saved = Total future payments - Outstanding principal
Interest saved = ₹4,18,824 - ₹3,35,000 = ₹83,824.
So, if Riya closes the loan, she will save ₹83,824 in interest.

Step 2: Calculate penalty cost
Now let’s see what price Riya will have to pay for this saving.

Outstanding principal: ₹3,35,000
Penalty rate: 4%
Total penalty = 4% of ₹3,35,000 = ₹13,400.
Step 3: Compare and decide

Total interest saved: ₹83,824

Penalty cost: ₹13,400

Savings: ₹83,824 - ₹13,400 = ₹70,424

This calculation clearly shows that Riya is still earning a profit of ₹70,424 even after paying the penalty of ₹13,400. Therefore, pre-closing the loan in this situation is a very wise and beneficial decision.

When is prepayment beneficial?

When you are in the initial tenure of the loan, in the initial years of the loan, a large part of your EMI goes as interest. Therefore, closing the loan in the beginning helps you save more interest.

When the interest rate is very high, the interest rates of personal loans are also high. If your interest rate is 14% or more, prepayment is more likely to be beneficial.
When your net savings are substantial: As we calculated above, if you are still left with a large amount after paying the penalty, then close the loan without thinking.

When should you not prepay?
When you are in the last term of the loan
If only a few months are left on your loan, then you have already paid most of the interest on your EMI. In such a situation, paying a penalty to close the loan may not be of much benefit.
When the penalty is more than the interest saved
If your net savings are negative, then prepayment will be a loss-making deal.

Better investment opportunity
If you can invest the lump sum money in a place from where you can get a higher return (such as 15% or 16%) than the loan interest rate (such as 14%), then investing the money can be a better option.

At the cost of the emergency fund
Never make loan prepayments by breaking your emergency fund. An emergency fund is for your safety and is more important than loan repayments.
 

Disclaimer: This content has been sourced and edited from Zee Business. While we have made modifications for clarity and presentation, the original content belongs to its respective authors and website. We do not claim ownership of the content.