A personal loan is a very handy financing option when you require quick funds for various purposes. Whether it is for an emergency, funding your wedding, paying your medical bills, or any other reason, a personal loan can help. Once you’re through the trouble or once you are in a better financial position, you may consider prepaying your loan. Before you do so, you should weigh the pros and cons, and here’s what you need to know.
The pros of prepaying your loan
Save on total interest outgo.
One of the primary reasons to prepay your loan when you have the funds is to save on the interest. The interest you pay on your loan is essentially the cost of the loan. By prepaying the loan, you can reduce the cost. This is also why having a shorter loan tenure reduces the interest burden. The longer you take to repay the loan, the more interest you pay for it.
Improves credit score
Credit rating agencies look at your credit mix for your credit score – the ratio of outstanding secured and unsecured loans. A personal loan is an unsecured loan since it requires no collateral. Lenders usually prefer borrowers with a lower proportion of unsecured loans when giving out loans. Hence, paying off your unsecured personal loan can help enhance your credit score, making it easier for you to avail of different types of loans in the future.
Enhances loan eligibility
If you are applying for another loan, such as a home loan, it would significantly help if you prepay it. This is because one of the factors lenders look at while assessing loan applications is the borrower’s debt-to-income ratio. Here, they consider your existing debt burden compared to your income. The lower this ratio, the better your loan eligibility is.
The con of prepaying your loan
Primarily there is only one con to prepaying your loan. These are the prepayment or foreclosure charges. If your loan interest rate is fixed, your lender can levy prepayment charges of 3% to 5% of the principal amount due. This is why it is important to do a cost-benefit analysis before you decide to prepay your loan; here, you have to consider if the interest you will save by prepaying your loan will be higher than the prepayment charges to pay. Another thing to consider is that lenders tend to have a minimum number of Equated Monthly Instalments (EMIs) that they may require you to pay before you can prepay your loan.
Finally, you should also consider if prepaying the personal loan will put financial stress on you in the coming months. You should not use your emergency fund, savings, or the money you saved for short-term expenses or obligations to prepay your loan. If so, you may require applying for a personal loan again a while later to meet those financial obligations. Hence, think this through and undertake some financial planning.
