Do you have multiple personal loans?
And do you now feel a little bogged down with all those EMI payments every month?
It’s natural to feel that way, even if you had been careful in choosing personal loans when you needed money.
Personal loans aren’t cheap. And if you leave credit cards’ outstanding debt interest rates aside, then personal loans are indeed the costliest forms of borrowing. This is not to say that personal loans are bad. These are unsecured loans, and hence, lenders charge a higher rate of interest to protect (and compensate) themselves for the higher risk they are taking for lending money without security.
So what should you do if you have multiple loans and want to begin prepaying them?
The best way is to make use of mathematics.
And the maths of personal loans (or any other loan for that matter) is such that the tenure selected along with the loan amount and the interest rate determines your final EMI.
Ideally, you should try to keep the repayment period as short as possible. Although your EMIs for a short-tenor loan would be higher than a longer-tenure loan, it makes mathematical sense to reduce your total interest outgo.
But what to do if you have surplus money that you can use?
Many people think – Should I pay off my loans or invest for future goals? Or should I simultaneously tackle both? These and similar questions belong to a class of debate (Pay off Loans Vs. Invest), where to be honest, there is no one right answer. I have already written about this aspect in detail at Pay off loans Vs. Investing.
But let’s say that you have multiple loans and want to begin prepayment, then how should you go about it? And what should be the thought process?
Let’s discuss this in this post.
Remember that personal loan interest rates are quite high. And sometimes, it might be possible for you to pay your personal loan off in advance instead of waiting till the end of the loan tenure to fully pay it off. Why can this be helpful to you as a borrower? Because prepayment results in substantial savings in terms of interest costs since the personal loan rates are very high.
As a borrower, you have the option of making a part payment or full prepayment of the loan. And in either case, the borrower benefits more if the prepayment is done relatively early into the tenure of the loan.
Let me use a small example.
Suppose you take a personal loan of Rs 5 lac for 5 years at a 15% interest rate.
Your monthly EMI will be approx. Rs 11,895.
And in 5 years, you will repay Rs 5 lac as the principal and additionally, Rs 2.13 lac in interest costs. Here is how the regular loan repayment schedule (over 5-year loan tenure) looks:
Now let’s say that after a year, you want to make a prepayment. Do note that personal loans generally have a lock-in (~1 year). It is only after this lock-in period is over that the entire loan outstanding amount can be prepaid.
After the end of 1st year, you would have paid a total of Rs 1.42 lac (via 12 EMIs of Rs 11,895). Out of this, Rs 72,596 goes towards principal repayment, and Rs 70,143 goes towards interest payment. So the loan outstanding after 1st year is Rs 4.27 lac. If you decide to prepay the loan in full now (i.e., Rs 4.27 lac), then you stand to save about Rs 1.44 lac in interest.
But what if you instead decide to make the prepayment after completion of 3rd year?
After the end of 3rd year, you would have paid a total of Rs 4.28 lac (via 36 EMIs of Rs 11,895). Out of this, Rs 2.55 lac would have gone towards principal repayment, and Rs 1.73 lac would have gone towards interest payment. So the loan outstanding after 3rd year would be Rs 2.45 lac. If you decide to prepay the loan in full after 3rd year (i.e., Rs 2.45 lac), then you stand to save only about Rs 40,155 in interest.
So why has the interest saved reduced if you make a prepayment at the end of 3rd year instead of at the end of the 1st year? Because you would have already paid a lot of interest in the first 3 years.
Here is the combined summary of what we have discussed until now:
So if you were to ask, what the best way to manage your personal loan prepayments is?
Then the answer is simply to try and prepay the entire loan outstanding amount as early in the tenure as possible. This way, you forego less and less on interest. The more you delay your prepayments, the more interest is already paid, and less will be the interest savings when you make the prepayment.
Note – If you prepay your personal loan and have the choice of reducing EMI Vs. Reducing loan tenure, then go for tenure reduction by keeping EMI constant. Reducing the EMI will substantially decrease your interest savings, and hence, it’s best to minimize loan tenure by keeping EMI constant after personal loan prepayment.
But please don’t feel that if you have been unable to prepay in the initial part of the tenure, then there is no point doing it later on. The benefit of prepayment indeed goes on reducing as the tenure reduces. And that’s because the loan EMIs are structured in such a way that interest payments are higher during the initial part of the tenure. However, it may still be beneficial to prepay. So no matter when you make the prepayment and how much (full or partial) you prepay, you will, without doubt, save some interest. So if the interest rate on your personal loan is high, then try to do so early on in the tenure, and if you can’t, then doing it later on in the tenure is still fine.
The mathematics of part payment of personal loans also works on similar lines.
Part-payment of a personal loan is when you make a prepayment, which is not equal to the full outstanding amount. But it still works and helps you save interest as it brings down the principal amount, which in turn brings down the total interest eventually paid.
So as you may have noticed by now, there is a straightforward relationship between the amount you prepay + when you prepay it (during the tenure) and the savings you can make by minimizing the interest outgo on loan.
And if you have multiple personal loans (let’s not get into why and how you got into this debt trap), then you should make prepayments of that personal loan first, which has a higher rate of interest.
It’s a no brainer. Right?
So those are the significant advantages of prepayment and part payment of personal loans.
But the prepayment strategy will differ for different loans. So even though you can save a lot of interest by making prepayment or taking short tenure home loans, it is also worth mentioning that post-tax home loan interest rates are quite loan and can make a case for not prepaying. But the story is different for high-interest personal and other loans.
It is always advisable to do a detailed cost-benefit analysis before deciding to prepay any type of loan.