Making a prepayment can be a worthwhile strategy that allows borrowers to pay off their loans earlier. Common benefits include saving on interest, gaining financial flexibility, and becoming debt-free sooner. However, there are also key risks and penalties that you should watch out for before committing to a partial or full prepayment.
In this guide, we will go over the various forms of personal loan prepayment, how they work, and their benefits and risks. Understanding these aspects is crucial for anyone considering making additional payments on their personal loans to ensure it aligns with their financial strategy.
Understanding the concept of loan prepayment
A loan prepayment refers to when you make an extra payment during your loan repayment schedule. This payment may pay off the loan in full, or it may be a partial payment that reduces the remaining balance.
The purpose of loan prepayment is typically to reduce your overall debt burden and help you save money in the long run. Prepayments are often an excellent way for borrowers to save money on interest and alleviate their financial stress. Without needing to allocate money toward monthly installments for this loan repayment, they can focus on other goals that require their resources and attention.
Making a loan prepayment frequently comes with an extra penalty imposed by your lender, because lenders miss out on interest you would have otherwise paid if you close your loan early. To mitigate their losses, lenders will charge various fees depending on what is written on your loan agreement.
A loan prepayment is a valuable way to reduce your debt burden and interest costs, but it may also have undesirable effects on your savings, credit score, and other financial obligations. That is it is important to carefully weigh the pros and cons of making a loan prepayment before you commit to the decision.
Benefits of prepaying personal loans
If you choose to prepay your personal loans, there are many potential benefits that you could reap. Here are some of the most common advantages given to borrowers who make loan prepayments.
Interest costs reduction
To understand why interest is reduced when you make a prepayment, it’s important to know that a prepayment goes toward lowering your principal balance. This is the amount you initially borrowed and now need to repay. Interest accumulates on this principal amount and is part of the cost of taking out the personal loan. Because your loan prepayment decreases your principal balance, less interest should end up accruing.
If you have obtained a loan with a long loan tenure or high interest, making prepayments could save you a significant amount on interest.
Making a loan prepayment helps you lower your debt burden. Since being in debt can cause feelings of stress and anxiety, it can be a huge breath of relief to reduce or even eliminate your debt through a loan prepayment.
If you make a partial prepayment, your outstanding balance will be reduced. This can help you lower interest costs and make future installments easier to afford.
By making a full prepayment, you can close this personal loan, officially ending this particular debt.
Changed credit score
Depending on how you approach the process of making loan prepayment, your credit score may either increase or dip. However, if you make a prepayment, decreasing your debt burden and how much you need to pay in interest, it can become easier to make monthly installments in the future. This can make it more likely for you to avoid late payments, which can help you maintain a good credit score.
Gives you the chance to close your loan early
Closing a loan early can help you focus on other priorities. It allows you to set aside your savings for other financial and long-term goals. Many borrowers find prepayments an attractive option since they allow for extra financial flexibility and freedom.
How to calculate prepayment charges
Knowing how to calculate prepayment charges can give you an advantage and help you make an informed financial decision. Prepayment charges are calculated differently depending on your lender and your loan agreement. First, you will need to review your signed loan agreement to see what type of prepayment charges may be imposed.
If there is a flat, fixed fee, that will be charged regardless of whether you make a full or partial prepayment.
If there is a fee based on your outstanding balance, then the rate might change based on how much of the total balance is left at the time you make the prepayment. This means that if you’re making a prepayment early in the loan tenure, it will cost more than if you choose to make the prepayment later in the repayment schedule.
Some lenders charge you a penalty based on how much interest they are losing out on, or they use another method to determine prepayment charges.
To ensure that you are accurately forecasting your prepayment charges, you may want to reach out to your lender to clarify the terms. You don’t want these penalties to sneak up on you only after you have already submitted the prepayment.
Factors to consider before making a prepayment
Before you commit to making a prepayment, there are certain factors to consider.
The impact on your credit score
Despite allowing you to close your personal loan early, making a prepayment could damage your credit score, at least temporarily. Because of this, you may want to delay a prepayment until you know a slight dip in your credit score won’t affect your goals and needs.
Some lenders impose prepayment penalties and fees on those who make a full or part prepayment. Because of this, it is essential that you double check if there are any prepayment penalties on your loan agreement.
In many cases, the prepayment penalty does not dissuade borrowers from making the prepayment to close the loan early. This is due to the myriad of benefits that are associated with making personal loan prepayments.
Will the prepayment burden you financially
Rushing to make a loan prepayment could be detrimental to your overall financial stability and credit health. Generally, it is not a good idea to pay off your loan early or make extra payments if the full or part prepayment will end up hurting your ability to afford living expenses or other debt obligations.
Consider whether the following example financial obligations and needs will clash with the loan prepayment you want to make:
- Day-to-day living expenses, such as groceries
- Rent or mortgage
- Emergency fund savings
- Credit card bills
If you won’t be burdened by the opportunity or prepayment penalty costs associated with making a loan prepayment, then it might be a good choice for you.
Will you have enough left in your emergency savings?
Unexpected incidents can occur that may come with costly yet necessary expenses. For example, an accident or medical event could result in hospital bills. A natural disaster could result in the need for urgent home or vehicle repairs. There are so many unforeseen circumstances that could arise, leading to the need for emergency savings.
The general rule of thumb for how much to save in your emergency fund account is that you should keep at least three to six months’ worth of living expenses in it. In addition, you should avoid dipping into the emergency savings account unless you need to urgently pay for something.
Because of these guidelines associated with proper emergency fund management, it is advisable to not use your emergency savings for a loan prepayment unless you are certain it is a good idea.
Does making the prepayment affect your other debts?
If you have other bills and balances that need to be paid, it is typically a good idea to focus on the bills that are the most urgent–such as if there is a high interest loan you need to tackle. If making a prepayment on this particular personal loan will interfere with your other loan or credit debts, you might need to reconsider.
Different methods of making prepayments
There are two main types of prepayment methods. The main kinds of prepayment are:
Full loan prepayment: You would pay off the entire outstanding loan balance in a full prepayment before the loan tenure is over. This allows you to close the loan early in one go.
Partial loan prepayment: You would repay a portion of the outstanding balance before it is necessary to repay that amount. This essentially serves as an extra payment installment that lowers your principal amount while still keeping the loan active. After this, you may want to make more partial prepayments, eventually closing the loan early.
How prepayment affects the loan tenure
Making a prepayment can help you shorten the loan tenure because the remaining balance on your account will be reduced.
Prepayment vs. foreclosure: what's the difference?
Prepayment: Lets you pay off a portion of or the entire loan balance before the scheduled loan tenure is over.
Foreclosure: If you fail to make your loan repayment installments regularly or on-time or cannot meet the loan repayment terms properly, the lender may foreclose your loan. This typically occurs for secured personal loans, and a loan foreclosure will lead to your collateral assets being seized by the lender.
How to negotiate prepayment terms with lenders
Since prepayment can lead to you paying numerous extra charges and fees, you might want to consider negotiating loan prepayment terms with your lender. This is especially a point to consider if you have yet to sign a loan agreement yet. You may want to seek a lender with lenient or nonexistent prepayment penalties if you suspect you will want to pay off the loan early.
If you’re negotiating terms with your lender, remember to go into the discussion with a clear goal in mind. Stay professional and polite, which can increase your likelihood of a successful negotiation.
Prepayment penalties: what to watch out for
If there is a percentage-based prepayment penalty, it is particularly important to calculate the penalty costs before you make the extra payment.
Here are various kinds of loan prepayment penalties:
- Fixed fees: A fixed, flat fee is easy to understand because your loan agreement will state the precise amount you will be charged in case you pay off the loan before the designated loan tenure ends. In these cases, you may want to use a loan calculator to see whether this flat fee is more expensive than simply paying off your loan normally.
- Fees based on your outstanding balance: This kind of penalty is calculated by determining a certain percentage of your remaining balance when you make the loan prepayment.
- Fees based on your prepaid amount: You might be charged a percentage of the amount you are prepaying. The outstanding balance amount will not affect your penalty in this case.
You may have also heard about penalties such as step down (AKA graduated or declining) penalties. These are typically seen in commercial real estate loans, so you are unlikely to encounter them in personal loans.
Other than the kind of prepayment penalties you should watch out for, here are a few points you should keep in mind before you make a prepayment.
- The price of making the loan prepayment
- The opportunity cost now that you’ve spent this money on the full or part prepayment
- Whether you have other loans with higher interest rates that should be prioritized
Impact of prepayment on credit score
One important factor to consider when you think about making a full or part prepayment is the impact of prepayment on your credit score.
A loan prepayment does not necessarily help your credit score, even if you are showcasing your financial responsibility by having the funds to pay off your debt. This is because of the counterintuitive relationship between debt and credit score.
When you close a credit account, your credit score may go down because of the decreased credit mix, shortened credit history, lowered total credit limit, and other factors. When you make a full prepayment, you are essentially also getting rid of this loan account, which may lead to a credit score dip because a closed account no longer establishes positive credit history.
On the other hand, making a partial prepayment can have either positive or negative effects on your credit score. It serves to lower your credit utilization and debt, which may be viewed positively by a credit scoring model.
At the end of the day, there are multiple factors that determine how making a personal loan prepayment affects your credit score. You may wish to approach your creditor or a financial advisor to receive personalized guidance on how your full or partial prepayment can affect your credit score–especially if your credit score falls in a more precarious range.
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