EMI and higher interest costs associated with personal loans often persuade many to prepay or foreclose them. While prepaying personal loans can be beneficial in most cases, borrowers should carefully review a cost-benefit analysis of opting for it.

What works in favour of personal loan prepayment?

Saves on the overall interest cost

The primary reason for prepaying a personal loan is to save on the interest cost. A personal loan of Rs 5 lakh, availed at an interest rate of 13 per cent p.a. for a tenure of five years would result in an EMI outgo amounting to Rs 11,400. Your total interest cost in this scenario would be closer to Rs 1.83 lakhs. If you decide to fully prepay your loan after two years, then you would derive an overall interest cost saving of about Rs 72,000.

Borrowers often assume that only prepayment made in early stages of the loan tenure can lead to considerable interest cost savings. The truth is, you can save on the interest cost even if you prepay the loan in later years. Take the help of an online personal loan prepayment calculator to estimate total interest savings. Make sure you factor in prepayment fees and other costs, if any. Consider opting for the loan prepayment option only if it results in substantial net savings.

Lowers EMI/NMI or GMI ratio

Lenders prefer lending to loan applicants whose total EMI outgo - including existing and new loans - are within 50-60 per cent of their monthly income. If an existing borrower seeking to avail another loan exceeds this mark, they can improve their loan eligibility prospect by prepaying their personal loan. Doing so would lower their monthly loan repayment obligation within 50-60 per cent of their monthly income.

Lowers concentration of unsecured loan in credit mix

Credit mix refers to the ratio of outstanding secured and unsecured loans. Credit bureaus give weightage to credit mix while calculating your credit score. Since lenders usually prefer lending to those with a higher concentration of secured loans (home loan, car loan, loan against property in their loan portfolio), credit bureaus tend to assign higher credit score to such borrowers. Given that personal loans are unsecured in nature, prepaying such loan will reduce the percentage of unsecured loans from your portfolio and thereby, reflect positively on your credit score.

What works against prepaying personal loans?

Prepayment charges

RBI has barred lenders from levying prepayment fee on loans availed at floating interest rate. However, in case of loans availed at fixed interest rate, lenders are free to levy prepayment fees on loan prepayment. Most lenders charge prepayment penalty of up to 5 per cent of the principal outstanding. Many lenders also disallow part-prepayment before the repayment of a predetermined number of EMIs by the borrowers.

Adverse impact on liquidity

Higher interest rate burden often lead borrowers to either use their emergency funds or investments earmarked for crucial financial goals to prepay their personal loans. But doing so can adversely impact your financial capacity to deal with financial emergencies or income loss due to job loss, disability, illness and such.

Dipping into investments earmarked for crucial financial goals can force you to avail loans at a higher interest rate later on. Hence, opt for prepayment option only if you have adequate surpluses after factoring in your emergency fund, crucial investments and monthly contributions towards long-term financial goals.

The author is Senior Director & Head of Unsecured Loans, Paisabazaar.com

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.