Life has its ups and downs and sometimes you might face a situation where you need a little extra money. A loan comes in handy at such times. But it may occasionally happen that your financial situation turns around faster than anticipated and allows you to pay off a sizeable chunk of the loan and clear as much debt as possible.

Paying off your debt faster will help reduce the total interest charges, and this in turn means you spend less time in debt. So far so good. But before you walk into the bank flashing a wad of cash, familiarise yourself with some facts. It’s understandable why there’s a penalty for delayed payment, but did you know that one can be penalised for early repayment as well?

What is prepayment penalty?

As the name suggests, a prepayment penalty is a monetary burden you have to bear when you pay your loan off earlier than specified in the agreement. If the terms and conditions of your loan agreement contain a prepayment clause, you will be penalised if you clear your debt early.

If you feel this sounds counterintuitive and are wondering why no one would want all their money at one go, think of it this way – when you repay a loan early, the lender will not get the expected interest (for lenders, the interest is their profit). Hence this clause is often put in place.

The amount can vary and the practice isn’t universal. It would depend on the lender’s terms and conditions. To find out, you should read the fine print before you sign on the dotted line.

How to calculate if it’s worth it

Typically, if there is no prepayment fee imposed by the lender you will benefit by repaying your loan sooner. Even if this clause is in place, you could still save some money. It would all depend on what the penalty fees are and how much of the loan you have left.

First of all, you need to determine how much you will save by paying early. You can calculate this by adding the total interest for the remaining tenure plus any ongoing fees. This final value is what you stand to save if you decide to repay your dues at present.

Subtract the prepayment and other fees from the above amount. Pay attention to the kind of fees levied – whether flat or on a percentage basis. The remainder value is what you will save by paying your loan early. A negative figure denotes more cost than savings.

Pros and cons of early repayment

If you’re confident you can pay off your loan early, it makes sense to look for a lender who does not have a prepayment clause. But not all of us can be similarly foresighted. However, even if a penalty is levied, prepayment can be a good or bad decision depending on the type of loan and your outlook. Take your pick.

Pros:

Less interest translates to more money saved
Improved credit score if you’re free of debt
Free money to use for whatever you please – reinvesting, splurging, etc
Opportunity to get a new loan which might offer a better rate
Ongoing fees can be avoided
Cons:

Interest on business loans is deductible and you will lose this deduction
You might lose a significant amount through prepayment charges
The bottomline

Prepayment penalty is an important factor to consider when taking a loan. Though early loan closure may not be on everyone’s radar, you never know what can happen in future. So, take all these factors into account. Just having the choice of being able to clear your debt early might be enough to give you peace of mind.

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