Now’s the time to prepay your loan

With the scrapping of pre-payment charges on term loans, foreclosing or porting your loans has become cheaper

Rajalashminirmal :BL: 15 June 2014

In April, the Reserve Bank of India directed banks not to charge customers for pre-closing term loans taken on a ‘floating rate’ basis. Until this order, banks charged a foreclosure penalty of 3-4 per cent of the outstanding loan amount.

Now, you might be looking for that catch in the fine print or you may simply be wary of switching your loan to a cheaper lender. Read on to clear some of those lingering doubts.

Who can close?

With the latest directive, foreclosure charges have been removed on all term loans, not just home loans. That includes vehicle loans, loans against property and personal loans.

Pre-payment penalty on loans has been removed without any condition on source of funds, says Harsh Roongta, Founder and CEO of apnapaisa.com. But take note.

It should be a loan to an individual on a floating rate and from a bank, he emphasises. So if you have taken a loan from a non-banking finance company (NBFC), you don’t benefit from the RBI order.

If it’s a floating rate loan from a bank, you can pre-close it with your own funds or even with funds arranged from another bank or a third party without being penalised.

Apart from closing out your loan with some surplus cash, you can port a loan to another bank that offers lower rates without suffering penalties.

Easier porting

Expectations are that the RBI may cut policy rates in the medium term. If such cuts are passed on by the banks, the interest rate for borrowers will start declining. Typically, banks are reluctant to pass on reduced interest rates to existing customers while new ones get the benefit immediately. So, if your banker doesn’t give you reduced interest rates, you can port to another bank whose rates are lower. However, note that at the bank to which you are switching, processing charges on the loan will still apply.

The could vary from anywhere between 1.8 per cent and 3 per cent, depending on the bank.

When you switch your loan, it is important to check if the rate you get is low enough to cover the processing charge and still leave you some saving in interest cost. Transferring a loan is not cumbersome, says Adhil Shetty, CEO of bankbazaar.com. You just have to file the home-loan transfer application online or at the bank’s branch and provide supporting documents. Then, both the banks exchange certain documents, at the end of which your loan will be transferred. An added advantage of pre-closing a loan is that it also improves your credit score.

With lenders looking at an individual’s CIBIL score before approving a loan, your pre-payment of loans can boost your score.

When to pre-close?

The other important question is when is the best time to pre-close your loan. This depends on two factors. One, if the surplus you have in hand will earn lower returns than what you pay as interest currently, you may be better off pre-closing the loan.

Let’s say you have two years left on your personal loan, for which you pay a 15 per cent interest rate. If the maximum, safe return you get on the money in hand is less than 15 per cent, you should pay off the loan.

This is because the amount you earn on investing that sum is less than what you will be paying on the loan.

Another factor that could influence the decision is which part of the loan tenure you are in.

Generally, it pays to pre-close the loan when you are in the early part of the payment cycle since the savings you make will be immense. Your savings won’t be much if you close the loan in the last stages.

This is because you would have serviced almost all your interest due on the loan and would be paying back only the principal in the final months.

For example, if you have taken a personal loan of ₹5 lakh for a tenure of five years at 16 per cent, the total amount payable by you will be ₹7,39,540.

Of this, ₹2,29,540 is toward interest and ₹10,000 toward the processing fee.

At the end of two years, if you decide to pre-close the loan, you would have to settle an amount of ₹3,45,849 with the bank.

This gives you a saving of over ₹91,000 from the amount initially due to the bank (₹6,47,666 vs ₹7,39,540).

 So, if you have some surplus cash at your disposal, don’t let it idle in your bank account. There are a lot of EMI calculators on the Internet that can do the math for you on the outstanding loan amount, so make use of these to take an informed decision.