Paying monthly EMIs on your home or personal loan can cause a strain on your finances. With money tied up in loan repayments, you may not be able to sufficiently plan for other financial goals. Prepaying your loan before the end of the selected term (either in part or full) can help you eliminate the debt burden ahead of schedule. To prepay a loan, you need to pay more than the EMI amount. This article discusses the top benefits of prepaying your loans in detail.
Top 5 benefits of prepaying your loan EMIs
Reduced interest costs
Interest costs on a long-term loan can be hefty to manage. Loan prepayment can help solve this issue, lowering the overall cost of your loan. By making partial prepayments during the loan tenure, you can effectively reduce the principal amount. Since interest is calculated on the principal outstanding, prepayments will help bring down the interest costs as well for the remaining repayment duration. Let’s say, you obtain a home loan of Rs. 80 Lakhs at an interest rate of 8.5% for 20 years. The existing EMI for loan is Rs. 69,426. You have windfall gains of Rs. 1.5 Lakhs and decide to channelise them towards prepaying your loan. In this case, your EMI will reduce to Rs.68,113, resulting in interest savings of 1,63,819. If you make a second prepayment installment of Rs. 2 Lakhs, your interest savings will amount to Rs. 3,79,301.
Become debt-free faster
Prepaying your loans allows you to become debt-free faster. This can be a compelling reason for most borrowers since EMI payments take up a significant portion of your monthly income, hampering savings and investments. When you opt to prepay a loan, the prepayment calculator allows you to select between EMI reduction and tenure reduction options. If you wish to become debt-free faster, you can choose to continue with the same EMIs and shorten your loan tenure. Eliminating your debt burdens faster offers an added peace of mind as well since you don’t have to worry about missing payments.
Improve your credit score
Banks and NBFCs check your credit score before sanctioning any form of credit. Maintaining a good credit score of 750 and above positions you as a credible borrower, helping you qualify for better loan offers. Prepaying your loans can help lower your credit utilisation ratio – which is a ratio of the amount of credit you use from the sanctioned line. A lower credit utilisation ratio has a positive impact on your credit report, improving your overall credit score. A good boost to your credit score will help you obtain loans at lower interest rates and better terms in the future.
Reduce your debt burden
When you make partial prepayments towards outstanding loans, you effectively lower your total debt burden. Reducing your debt burden can help ensure sound financial planning. Making part prepayments early can reduce the overall cost of the loan and lower your EMIs. With lesser funds being diverted to loan servicing, you can use your resources for other important goals like retirement planning. Moreover, you can also utilise savings to make essential major purchases from online marketplaces and offline stores.
Improves chances of availing other loans
As mentioned earlier, prepaying loans improves your credit score, instantly enhancing your chances of securing other loans. Apart from this, prepaying loans in full also lowers your debt-to-income ratio. Lenders assess this ratio to ascertain your loan repayment capacity. Generally, a high debt-to-income ratio is considered risky. Prepaying loans allows you to become debt-free faster, making you eligible for other essential forms of funding.
Things to remember when prepaying loans
Given the various benefits of loan prepayment, you may be tempted to prepay your loan at the earliest. However, before you do so, carefully understand the following considerations:
- Prepayment fees can range from 2%-5% depending on the lender. Rates may also vary for partial and full prepayments.
- Depending on the lender’s policies, the prepayment fee may be charged on the prepaid amount or the outstanding balance.
- Lenders also have minimum 1-year lock-in periods when no prepayments are permitted.
- Some loans like home loans obtained against floating interest rates have zero prepayment fees.
Conclusion
Prepaying your loan EMIs can offer several benefits including interest reduction, tenure shortening, and credit score improvement. It can also help you divert the saved funds towards other financial goals like funding your child’s education or planning retirement. However, before you opt to prepay EMIs, it is essential to consider the costs associated with such payments. Prepaying loans only makes sense if the interest savings on the loan exceed the prepayment fee charged by the lender.