Monday 7 January 2013

Prepayment of Loans: Is it wise decision?


Nowadays loan has become very necessary to purchase a car, purchase a home, for higher education and many several purposes. In fact if we look the whole picture, almost all the companies, businesses and individuals takes loan for several purposes. Because we believe in invest the capital to earn money and acquire things on loan by this mean our both purposes has been solved, as we will have cash as well as our need will fulfill. Nobody wants to take risk to engage surplus fund for acquiring things and blank oneself.


Now the thing is that when we go for a loan is it wise to prepay loan and why we should prepay the loan.


Prepayment of loans is the payment of the due balance amount or the part of the due balance amount on that date before the tenure completion for saving interest and reduction of financial liability.



Prepayment is of two types:

1) Partial Prepayment
2) Full Prepayment

In the Partial Prepayment some part of due amount has been paid to save interest of that period.

In complete Prepayment full due amount has been paid to save interest and reduce liability.

If we take a loan of Rs. 1,00,000 on interest rate 10 % for 3 year. Suppose that EMI will be Rs.3227/ month. Now if we pay a whole due amount after 2 months it will be called Full Prepayment and if we pay a part of due amount it will be called Partial Prepayment.

Suppose that after paying 12 months EMI’s of Rs.3227 the amount due is Rs. 69926 for 2 years. Now if one pay (69926-36702=33224) Rs 33224 for second year, he/she can save the interest on this amount i.e. Rs.5, 497 and he/she have to pay amount due on the completion of second year.


Year
Principle
Interest
Principle +Interest
Balance
1
30,075
8,646
38,721
69,926
2
33,224
5,497
38,721
36,702
3
36,703
2,018
38,721
0.00

After partial prepayment one has two options. First is he can pay according to 3rd year schedule and can pay the loan before loan tenure and the second option is he/she can also reduce the amount of monthly EMI for the same tenure.


The prepayment is good or bad this depends on the following factors:

1) The interest rate is fixed or fluctuates: If one has taken a loan with a fixed interest rate then it is certain that he has to pay according to a certain rate so the other fluctuating factor is time period only. So you can save interest only by prepaying but if the interest rate is fluctuate type then it’s hard to decide that prepayment is beneficial or not.

2) The interest rate of other investment instruments:  Suppose you are prepaying  on the 9 % interest rate and some other investment instrument is giving you 11% interest rate for the same time in this condition if you are prepaying a loan to save interest rate 9% actually you are getting under the value of your asset. For this before prepaying one should look at other investment option.

3) Psychological factors: Along with above factor we cannot ignore one’s psyche. This is a very important factor. Some people who have not very strong background on have not fix source of income wants to complete loan as soon as possible for feeling secure after all loan is a big financial liability. In this case one doesn’t see the small margin and want to pay loan ASAP.
After all this you have to decide that prepayment for you is a wise decision or not because everyone’s has its own conditions in which they have to survive.


Good Luck...