Prepaying a loan when there is some amount of additional funds at hand is a good idea but it does require one to carefully analyze the implications in terms of interest saved and opportunity missed. The basis of any such calculation should be what are the short term as well as long term consequences of prepaying a loan. People today have multiple loans running concurrently which they have availed for various purposes. When the opportunity does arise to prepay some amount of it one needs to prioritize the loan which is best liquidated at the earliest.
The Interest Factor
In terms of interest the personal loan is highest among all types of loans available in the market currently. Thus it is smart to eliminate the personal loan so as to save more in terms of interest that has to be paid till the end of the tenure of the loan. On a loan of Rs. 100000 the interest rates will be as depicted in the table below.
|Loan Instrument||Interest Rate||Annual Interest|
|Credit Card||36%||Rs. 36000|
|Personal Loan||18%||Rs. 18000|
|Car Loan||13%||Rs. 13000|
|Educational Loan||12.5%||Rs. 12500|
|Home Loan||11%||Rs. 11000|
It must be noted at this stage that the interest paid on some loans is exempted from income tax. The entire amount of interest paid in an education loan and up to Rs. 150000 of interest paid in a home loan per year is exempted from income tax. Paying off such loans early may actually hurt your savings in the long term.
The Tenure Left
In standard calculation of loans of every kind the initial EMIs contribute mainly to the interest element. Thus prepaying a personal loan that has only a few EMIs left may not be advisable against paying off a car loan that has just commenced despite the fact that the car loan is at a lower interest rate as the personal loan now has only principal element left in the final stages.
The Default Factor
One needs to consider the possibility of consequence in case of a default at a later stage while deciding to prepay a loan. If one defaults on a few EMIs of the personal loan the credit rating will be affected negatively but in the same situation for a car loan the car may be recovered by the bank. In case of home loans there will not be any significant concern unless the default period is extended.
The Opportunity Factor
Another aspect that deserves consideration while deciding on prepayment of a personal loan is the kind of investment avenue that one has access to at that point of time. It may not be smart to prepay a personal loan on which you are paying 16% loan while missing out on an opportunity which has assured returns of 18-20%.
Taking into account all the above discussed factors the burrower will have to prioritize the prepayment options whenever such a situation present itself in term of availability of extra funds.