Managing loans effectively is essential to maintaining financial health and stability. As a borrower, your focus must not only be on making regular monthly payments but also on reducing the overall cost of a loan or shortening the loan term. Fortunately, there are multiple strategies that you can employ to do so. The strategies include part payment, pre-closure, and prepayment of loans.
With these strategies, you can be flexible in managing your debts and can enjoy significant savings over time. In this article, we will be exploring the meaning of part payment, prepayment, and pre-closure along with examples to help you make informed decisions.
What is Prepayment of a Loan?
Loan prepayment refers to the act of paying a lump sum amount towards a loan before the payment is due. This extra lump sum payment goes directly towards reducing the principal balance of a loan.
The reduction in the principal balance of the loan leads to a reduction in the overall interest paid on it. As a borrower, you can choose to either pay a reduced EMI or keep the EMI as it was before and shorten the loan tenure.
Prepayment of a loan can be of two types: part prepayment or full prepayment. In a part prepayment, you only pay a part of the outstanding principal loan balance, whereas in a full prepayment, you pay the entire outstanding principal loan balance.
Loan prepayment is disadvantageous to lenders since it leads to them missing out on the interest payments. Therefore, to discourage borrowers, lenders often have prepayment penalties or restrictions. If you plan to prepay your loan, you must always check your loan agreement or consult with your lender before committing yourself to it.
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Prepayment of a Loan: An Example
Before we look at what pre-closure is, let us take up an example to illustrate how prepayment works:
Assume you have a ₹2,00,000 loan with a 5-year term and an 8% annual interest rate. Your regular monthly payment would be approximately ₹4,055. If you pay the EMI throughout the entire tenure without making any prepayment, the total interest you would have paid would amount to ₹43,317.
During the first year, you pay off ₹33,888 in principal and ₹14,772 in interest, leaving behind a loan principal of ₹1,66,112 (₹2,00,000 – ₹33,888).
Now, let us assume that you make a lump sum prepayment of ₹1,00,000 after a year of paying EMIs. The remaining loan principal would only be ₹66,112 (₹1,66,112 – ₹1,00,000). Your EMI would be revised to ₹1,614 per month for 4 years, leading to a total interest payment of ₹11,359 on the remaining loan principal balance.
With a loan prepayment of ₹1,00,000, you managed to save ₹17,186 in interest payments (₹43,317 – ₹14,772 – ₹11,359).
What is Part Payment in a Loan?
Part payment, also known as partial prepayment, involves making a payment towards the outstanding principal loan balance without closing the loan entirely. The primary goal of part payment is to reduce the principal amount, which then reduces the overall interest that you pay over the remaining loan term.
Part Payment of a Loan: An Example
The hypothetical example that was discussed under the prepayment of a loan is a good representation of partial prepayment of a loan. This is because you only make a partial prepayment of just ₹1,00,000, leaving behind an outstanding loan principal of ₹1,66,112.
What is the Pre-Closure of a Loan?
Loan pre-closure, also known as loan foreclosure, refers to the process of fully paying off a loan before the end of the tenure. This involves settling the entire outstanding principal amount along with any accrued interest and applicable fees in one lump sum payment.
Unlike prepayment of a loan where you continue making reduced loan payments, the loan account is completely closed when you opt for a pre-closure. It is often considered to be an attractive way to eliminate debt, especially if you have idle funds or windfall gains.
As with prepayment, pre-closure also entails a penalty. The penalty is designed to compensate the lender for the interest they would have earned if the loan had continued for its full term.
Loan Pre-closure: An Example
Let us take the previous example to understand what pre-closure is.
At the end of the first year, you would have paid off ₹33,888 in principal and ₹14,772 in interest, leaving behind an outstanding loan principal of ₹1,66,112 (₹2,00,000 – ₹33,888).
Now, if you pay the entire outstanding loan principal of ₹1,66,112 to the lender, you would effectively pre-close the loan. This pre-closure would help you save ₹28,545 (₹43,317 – ₹14,772) in interest payments.
Conclusion
With this, you must now be aware of what part prepayment is and what the concepts of prepayment and pre-closure entail. These are powerful strategies that you can use to manage your loans more effectively. That being said, the choice between these strategies must always depend on individual financial situations, goals, and the specific terms of the loan. Also, it is important to consider factors such as prepayment penalties, current interest rates, and your overall financial plan when deciding which strategy to employ.
FAQs
Are there any disadvantages to prepaying a loan?
Although prepayment is generally considered to be beneficial, some potential disadvantages include prepayment penalties and missing out on tax deductions for interest payments (if the loan is a home loan).
Can I make prepayments on any type of loan?
Most loans allow you to make prepayments. However, some may impose certain restrictions or penalties. Therefore, it is always a good idea to check your loan agreement or consult with your lender before deciding to make prepayments.
What is the difference between part payment and prepayment of a loan?
A prepayment involves paying off the entire outstanding loan balance or a part of it by making a single, one-time lump sum payment. The meaning of part payment is paying off a part of the outstanding loan balance through a one-time lump sum payment. It is one of the two types of prepayment methods.
Can making prepayments or part payments affect my ability to get future loans?
Prepayments and part payments do not negatively affect your ability to get future loans. In fact, it may lead to an improvement in your credit score by reducing your debt-to-income ratio.
How do I know if prepayment or pre-closure is the right choice for me?
To determine if prepayment or pre-closure is right for you, consider factors such as your interest rate, other debts, investment opportunities, and overall financial goals. If your loan interest rate is higher than the returns you might get from investing idle funds, a prepayment or pre-closure might be beneficial since it allows you to save on interest costs.
