One avails loans to meet various needs in life, like home loans, vehicle loans, personal loans, education loans, business loans and so on. A major responsibility is then to repay these loans. One can go for the more common ‘repayment throughout the entire loan term’ or a few opt for ‘Prepayment or Foreclosure of their loans’. Whatever manner they choose to close their loans, one has to understand the terms of loan repayment to take advantage of the benefits offered by banks to borrowers.
Loans are an ideal way of meeting fund requirements faced by an average family man. Lending holds majority stake in the entire banking business in India and everywhere elsewhere in the world. Banks & NBFCs allocate a huge percentage of their annual budget towards lending. They also set numerous terms & conditions towards the repayment of loans. One has to make regular EMI payments as agreed. They are given the option to deposit any surplus money they come upon at times, against their loan amount, to reduce the interest liability. This article sheds some light upon the features of Prepayment & Foreclosure of loans, their benefits and disadvantages to a borrower.
What Is Prepayment Of Loan?
Prepayment is a facility that allows you to repay your loan, either in part or in full, before the end of the loan term. It allows you to invest any surplus funds you come across into your loan account. It reduces the total outstanding principal, thus reducing the interest liability through the EMIs or by decreasing the remaining term of the loan in exchange. This is common amongst borrowers who get regular annual bonus or some kind of yearly incentive on their job.
You can make partial payments into your loan account from your other accounts online. Since loan interest is calculated based on daily reducing balance, the interest and EMI will be adjusted based on the latest outstanding on your loan account.
What Is Foreclosure Of A Loan?
Foreclosure is a legal process where the borrower repays his debt in full before the term of the loan ends. This helps them in significantly reducing the interest liability and closing down the loan account well before its tenure.
One has to submit an application for foreclosing a loan to the respective bank or lending institution. The lender shall determine the foreclosure balance taking into account the total outstanding obligations, interest paid and the remaining term of the loan and give you a quote. Once you are satisfied with the calculation, you can pay the amount and close the loan. Remember to collect the original documents, no dues certificate and related documents from the bank or lending institution.
Prepayment Or Foreclosure Charges
As per a recent RBI guideline, dated August 2nd, 2019, banks and NBFCs have been instructed to do away with the Foreclosure/Prepayment penalty charges for floating interest rate term loans given to individual borrowers (with or without co-applicants) for purposes other than business. So, the borrower has to make sure that the lender has not included any prepayment penalties on the foreclosure amount calculation.
Why Should You Go For Prepayment Or Foreclosure?
Whether one decides to Prepay or Foreclose their loan, it definitely is a benefit on the longer run. Both these facilities benefit lakhs of borrowers who can use any surplus money they come across to close off existing loans and get some respite from the high interest amount towards their loans. That too in India, where the idea of being indebted is generally seen with some amount of abhorrence, closing down their loan account is favoured greatly. Prepaying or foreclosing your loan account can give you the following benefits:
Reduce the overall interest liability on the loan. At the average ROI of 10.5% on home loans, borrowers end up paying about 100% of the principal amount as interest on a 20 year home loan. By prepayment or foreclosure, you can reduce this huge interest burden.
Increases your credit score. Though there wouldn’t be any difference initially, foreclosing a loan will have a lasting effect on your credit score due to your repayment history.
Prepayments towards home loans are considered for tax deduction as they are, in principle, repayment towards the principal amount of the home loan. This will give you a higher tax rebate in the year where you make even a partial prepayment towards you loan.
You can opt for reduction in repayment tenure, thus allowing you to become debt free earlier than expected.
Prepayments need not be just once. You can make multiple part payments towards your loan. This allows you to make prepayments whenever you have some extra money in hand.
Additional Reading: How Pre-closure of Personal Loan Can Impact Your Credit Score?
Things To Consider Before Going For Prepayment Or Foreclosure
One has to check with the bank for prepayment penalties. Though RBI mandates no prepayment/foreclosure charges for floating interest rate loans, personal loans or others with fixed interest rates are exempted from this rule. Banks charge anywhere between 4-5% of the outstanding loan amount as prepayment charges on personal loans. The idea of prepaying a loan is to reduce the interest burden. If the prepayment charges are high, it invalidates the prepayment benefits. So, calculate the prepayment charges as against the interest benefits you will be gaining before going in for the prepayment or foreclosure.
Explore options to invest the surplus money if you can reap better returns. The average interest rate one pays on a home loan is about 10.5% and on a personal loan is about 15%. When you make a prepayment, you are trying to beat this interest burden. However, should you consider investing this amount in mutual funds or other market linked instruments to reap better returns? That is something to think about.
Consider the limitations on the tax benefits under sections 80C and 24b. One can avail tax benefits for up to Rs.1.5 lakh for the principal part under Section 80C and deductions up to Rs.2 lakh for interest payments on housing loans under Section 24(b). Prepayments above this limit might not give you tax benefits.
Do’s & Don’ts Of Prepayment Or Foreclosure Of A Loan
Calculate the impact of the prepayment or foreclosure on the rest of your finances. Make sure that this prepayment/foreclosure is not eating in to other savings like retirement planning, child future or health care for family.
Evaluate the tax benefits you might lose by foreclosing your home loan. Find out if the tax rebate you are receiving from the home loan is more or less from the interest burden you will save by foreclosing or prepaying the loan.
Choose to prepay loans in the beginning of the loan tenure as against to prepaying at a later date. Interest liability is highest at the beginning of the loan tenure and so prepaying during this period will get you more benefits than prepaying at a later date, when the benefits might not be as much as expected.
Think twice before opting for balance transfer of loans. Many banks and NBFCs offer attractive offers to customers willing to transfer their existing loans to their institutions. However, the processing fees and other charges levied might be high and completely undermines the purpose of balance transfer. Calculate all the charges and compare them against the benefits of balance transfer before opting for one.
Do not opt for a higher EMI with the idea of having a shorter repayment tenure. Salaried individuals are opting for higher EMIs expecting to close down the loan earlier. However, this might not help with your credit score as higher EMIs will affect your debt to income ratio. This will have an effect on your future loans.
Additional Reading: Advantages Of Prepayment And Part Payment Of A Personal Loan?
Things To Do After Foreclosing A Loan
Once you have foreclosed a loan, remember to follow up on the below actions:
- Updating your credit report – The banks or NBFCs should inform the credit bureau about your loan being closed so that they can update your records. This may take up to 30 business days. However, it is your responsibility to follow up with the lending institution and make sure that this information is updated on your credit report to avoid any future issues. Many cases have been reported where the credit report has not been updated for years affecting the borrowers credit score.
- Get the lien on the property removed – Once a home loan has been repaid, the borrower has to make sure that the lien on the property has been removed at the Registrar’s office. Without doing this, the borrower will not be able to sell the property.
- Get the original property documents and other relevant documents from the lender – Collect the original property documents, NOC, Encumbrance Certificate and a written confirmation about the bank on the closure of the loan.
With so many lenders offering such attractive loan options, borrowers are, ironically, averse to being debt ridden. They would always want to repay their loan at the earliest and prepayment or foreclosure allows them to do just that. By investing their surplus money into their loan account, they are able to reduce the outstanding principal, and in turn get lower EMIs or a shorter loan tenure.