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Burdened by Personal Loan

Think about prepaying the personal loan but before taking this step you must base your decision on keeping few factors in mind.

Kairav Shah

02 Nov 2009

Burdened by ?Personal? Loan?

Consider Prepayment!

Feeling burdened by the personal loan which you had taken to fulfill the desire of visiting foreign shores? Memories you relish, loan you want to perish.

Think about prepaying the personal loan but before taking this step you must base your decision on keeping few factors in mind.

You are lured by the lenders making frantic calls to you for availing that personal loan which can give wings to your desires and you fall in the trap. But seriously speaking personal loans are an effective tool to meet any financial emergencies or contingency requirements like medical, marriage, family function, education, vacations, travel, home purchase, 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. Moreover personal loans are cheaper than credit cards, but more expensive than home loans.

Before opting for a personal loan, you must be aware of the method of calculation of Interest Rate. 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 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%, your Interest is going to be Rs. 30,000 per year for tenure of loan. In the case of reducing balance, the EMI and the Interest computation is equated in EMI?'s 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% flat and 10% reducing EMI method for same tenure, the reducing balance is a cheaper option. 

In Advance EMI, lenders normally take 2-3 EMI?'s 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 3 advance EMI?'s(Rs 30,000) of  Rs 10,0000 your loan may actually be for 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 are able to make a sound judgment on the prepayment of loan.

Now that you are considering pre-payment, 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 1 year, 2 year, 3 year or 5 year personal loan and you decide to pre-pay the entire amount, then banks would charge you anywhere in the range of  4% - 5% penalty.

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

If  you think that you have money available to you through other means and that the 4% cost is something you are willing to incur, you can pre-pay the loan.

Also, when the bank offer you the option of pre-payment 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 pre-payment is still the cheaper option, go ahead ?

Unburden yourself!