Things to Consider before Prepaying Your Personal Loan

You have taken a personal loan an year ago. Interest rates have moved down since and you can get a personal at a cheaper rate. Lower interest rate means lower EMI. Without any friction, you would move to the lower interest rate right away. i.e., take the new loan at a low rate and use the loan amount to close the high-cost old loan. Well, the banks wouldn’t like this, at least the one that gave you the old loan.

Therefore, there are costs to discourage you from prepaying a loan. The regulations allow banks/NBFCs to charge a prepayment penalty if you close a fixed rate loan. And personal loans are usually fixed interest rate loans. Depending on your loan terms, this prepayment cost can be up to 4% of the outstanding loan amount. And while the new bank is interested in getting business (you taking a loan from them), it is usually not satisfied with just the interest income. It needs some side income in the form of processing fees and other ancillary charges on a new loan.

So, prepayment penalty on the old loan and processing fee of the new loan are costs that you must bear. And what do you get? Lower EMI. You save some amount every month. If the loan tenure is long enough, perhaps these monthly savings will be worth more than the cost incurred. Remember, the loan tenure is important. If the loan tenure is too short, you wouldn’t likely be able to recover the cost.

So, there are 4 variables here.

  1. Cost of closure of existing loan (Prepayment or foreclosure charges)
  2. Upfront cost of taking a new loan (processing fee and other ancillary charges)
  3. Loan Tenure (assume it is same for the new and the old loan)
  4. Difference between the interest rates on the old and the new loan

It is fair to assume that the interest rate on the new loan must be significantly lower than the interest rate on the new loan, otherwise this entire exercise is meaningless.

Points to Note

  • Switching costs will be upfront, while the savings due to lower interest rate will be spread over the loan tenure. Thus, you must compare the upfront cost with the present value of discounted savings. However, to keep things simple, we will not consider the time value of money. We will just compare the absolute costs and savings.
  • GST will be applicable on upfront costs. GST is not charged on interest payments (unless you are talking about a credit card).

You would opt for refinance/debt consolidation/prepayment of the old loan if the upfront cost incurred to switch is significantly lower than the amount of savings.

 Case 1Case 2Case 3Case 4Case 5Case 6Case 7Case 8Case 9Case 10
Amount10 lacs10 lacs10 lacs10 lacs10 lacs10 lacs10 lacs10 lacs10 lacs10 lacs
Loan Tenure – Both Old and New (in Months)36363624123636363636
Old Interest Rate12%12%12%12%12%12%12%12%12%12%
Prepayment Penalty1%1%1%1%1%2%3%2%2%1%
New Interest Rate10%9%9%9%9%9%9%10%10%11%
Processing Fee (New loan)1%1%1%1%1%1%1%1%2%1%
Total switch cost (incl. GST)23,60023,60023,60023,60023,60035,40047,20035,40047,20023,600
Old EMI33,21433,21433,21447,07388,84933,21433,21433,21433,21433,214
New EMI32,26731,80031,80045,68587,45131,80031,80032,26732,26732,739
Interest Savings (loan tenure)34,09650,92550,92533,33016,76850,92550,92534,09634,09617,121
Net Savings10,49627,32527,3259,730-6,83215,5253,725-1,304-13,104-6,479

Case 1 is the base case. In the remainder of the cases, the changes from Case 1 have been highlighted in bold.

As you can see, the balance tilts in the favour of refinancing/switching when:

  1. The difference between the old and the new interest rates is higher.
  2. Prepayment cost of the old loan and processing fee of the new loan are lower.
  3. A slightly longer tenure helps recover the upfront switching costs.

This is quite expected too.

Refrain from Reaching Wrong Conclusions

Looking at the above examples, it might seem that the interest difference must be at least a couple of percentage points before this exercise becomes meaningful. That’s right, but that’s only for short-term loans.

For longer tenure loans (such as home loans), even a lower difference might be good enough since you have a longer loan tenure to recover the cost. Plus, home loans won’t have any prepayment costs either. However, things are never so simple. You might want to prepay your home loan sooner, which reduces the time to recover the switch costs. Secondly, the bulk of the savings will come much later, which makes it imperative to consider the time value of money. That discussion is for another day. 

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