How Does Prepayment of a Personal Loan Work?

Mar 173 min read

Updated: Mar 21

Taking out a personal loan helps you manage financial needs, but repaying it as early as possible can save you money on interest. This is where loan prepayment comes in. But how does it actually work, and is it always the right decision? Let’s break it down.

How Does Prepayment of a Personal Loan Work?

Understanding Personal Loan Prepayment

What is loan prepayment?

Loan prepayment simply means paying off your loan before the scheduled tenure. This can be done either in partial payments (reducing the outstanding principal) or full prepayment (closing the loan entirely).

Types of Prepayment: Partial vs. Full

Partial Prepayment: Paying a portion of the loan principal before the due date, reducing the interest burden. Prepayment of a Personal Loan
Full Prepayment (Foreclosure): Paying off the entire remaining balance before the original loan term ends.

How Does Prepayment Work?

Steps to Prepay a Loan

Check your lender’s prepayment policy. Not all lenders allow prepayment without penalties.
Calculate your savings—compare the interest saved vs. the prepayment charges.
Request a prepayment quote – Your lender will provide the outstanding amount and any applicable charges.
Make the payment – Use a lump sum amount from savings, bonuses, or extra income.
Obtain a loan closure certificate (if full prepayment). Ensures that your loan is officially closed.

Benefits of Prepaying a Personal Loan

Reduces total interest paid – The longer you hold a loan, the more interest you pay.
Improves financial freedom—eliminates monthly EMI obligations.
Can boost your credit score – A cleared debt improves your financial profile.

Things to Consider Before Prepaying

Prepayment charges: Some banks charge 2-5% of the outstanding loan amount as a penalty.
Impact on financial liquidity: Ensure you have enough funds left for emergencies.

Is Prepayment a Good Idea for You?

Use a loan prepayment calculator to estimate your potential savings and see if it makes financial sense based on your income and expenses.

Prepayment vs. Regular EMI Payments

Prepayment reduces interest but necessitates a one-time cash outlay.
Regular EMI payments ensure steady cash flow but higher overall interest.

Common Myths About Prepaying Loans

"Prepayment always saves money"—if "the penalty is high, it may not be worth it.
"Banks don’t allow prepayment" – Many banks do, but with conditions.

How to Avoid Prepayment Penalties

Choose loans with zero or low prepayment charges.
Negotiate with your lender if you’re a long-term customer.

Alternatives to Prepayment

Investing the extra money – If investment returns are higher than loan interest, consider investing instead.
Increasing EMI payments – A higher EMI can reduce tenure without penalty.

Impact of Prepayment on Credit Score

Full prepayment can slightly lower your score in the short term (due to credit mix changes).
Long-term impact is positive as it reduces your debt-to-income ratio.

Best Practices for Prepaying a Loan

Read the loan agreement carefully before deciding.
Time your prepayment wisely – earlier in the tenure saves more interest.

Real-Life Examples

Case Study 1: Partial Prepayment

Rahul had a ₹500,000 loan for 5 years. After 2 years, he paid ₹100,000 in prepayment. This reduced his interest payments and loan tenure significantly.

Case Study 2: Full Prepayment

Priya had a ₹300,000 loan and received a work bonus. She decided to fully prepay her loan, saving ₹50,000 in interest.

Conclusion

Prepaying a personal loan can be a smart financial move, but only if the savings outweigh the penalties. Before making a decision, analyse your finances, check prepayment fees, and consider alternatives.