Loan Prepayment Charges and How They Affect You?

Imagine working tirelessly to repay your home loan, eagerly awaiting the day you’ll finally be free of EMIs and achieve financial independence. But what if that day comes with a surprising twist-a hidden cost you hadn’t planned for? This unexpected cost is known as a prepayment charge or prepayment penalty, a fee that lenders impose when you decide to repay your loan early. While it serves to protect lenders from losing out on potential interest income, for borrowers, it can be an unanticipated financial burden.

In this blog, we’ll break down everything you need to know about prepayment charges-their types, the reasons they exist, the pros and cons, and strategies to avoid them.

What is Loan Prepayment?

Prepayment is a feature provided by some banks that allows borrowers to pay off their loan before the scheduled end date outlined in the loan agreement. This can be done either partially or in full.

What is a Loan Prepayment Penalty?

Prepayment charges, also known as prepayment penalties, are fees that lenders impose on borrowers who pay their loans earlier than the decided repayment period. It is particularly designed to compensate lenders for the loss of interest income they would have received if the loan was paid off according to the original terms. Usually, loan prepayment charges are calculated as a percentage of the remaining loan balance or as a specific number of months’ worth of interest. These can be applied to various types of loans including home loans, car loans and personal loans, and impact significantly the overall cost of the loan.

Prepayment charges usually don’t apply when you make a few extra payments or principal-only payments to pay off your loan sooner. Most mortgage lenders let you pay off up to 20% of the loan balance each year without penalties. However, these penalties typically apply when you refinance, sell, or pay off large amounts of the loan all at once.

Benefits of Loan Prepayment

• By prepaying your loan before the end of the tenure, you can save interest.
• Paying off your loans ahead of the scheduled tenure lowers your credit usage ratio. A lower credit utilization has a positive impact on your credit report and helps boost your overall credit score.
• A higher credit score also improves your chances of getting approved for other loans, like car, business, education loans etc.
• Protect you from missing payments in case of unexpected emergencies or tough situations, and being charged a penalty.

Types of Prepayment Charges

1. Soft Prepayment Penalty

A soft prepayment penalty applies only if the loan is refinanced or paid off during the early years of loan. If the property is to be sold, then the penalty is usually not applied.

Consider this example for better understanding:

Let’s say you have a 5-year fixed-rate loan with a soft prepayment penalty. If you decide to refinance your loan within the first 3 years, you might have to pay a penalty of 2% of the remaining loan balance. However, if you sell your home and pay off the loan with the sale proceeds, you won’t be charged this penalty.

2. Hard Prepayment Penalty

Unlike soft prepayment charges, hard prepayment penalty on loan applies in both scenarios- whether the loan is refinanced or the property is sold.

Consider the following example to understand better:

Suppose you have a 7-year fixed-rate loan with a hard prepayment penalty. The terms of the loan include a penalty of 3% of the remaining loan balance if you prepay the loan.

• Refinancing:
  You decide to refinance your loan after 4 years. Since you are prepaying the existing loan, you’ll have a 3% penalty on the remaining balance. If you still owe 200,000 on your loan, the penalty would be Rs. 6,000.
• Selling Your Home:
  You sell your home and use the sale amount to prepay the loan. You would also face the same 3% penalty on the remaining balance, resulting in a Rs. 6,000 fee.

What are the Reasons for Prepayment Charges?

• Lenders expect to earn a certain amount of interest over the duration of loan. However, when a borrower pays off the loan early, the lender loses out on the preplanned income that was expected.
• Prepayment penalties help cover the fixed costs such as administrative costs, including documentation that were expected to be spread over the loan term.
• Lenders face interest rate risk, especially if the loan has a fixed interest rate. If a borrower repays a loan when interest rates are declining, then the lender may have to re-lend the funds at a lower rate.
• Lenders design loan terms to ensure profitability. Early repayment can disrupt their financial planning and profitability anticipations.

How to Avoid Loan Prepayment Penalties?

• Thoroughly read the loan agreement before signing in order to understand if there are any prepayment penalties.
• Try negotiating with the lenders as some lenders may be willing to let go of the prepayment charges. Discuss your concerns during the loan application process and attempt to negotiate further to bring to more favorable terms.
• Many lenders allow small prepayments up to a certain percentage of the loan balance without penalties.
• Frequent refinancing can make lenders expect you to refinance when rates drop. Instead, try finding a co-signer or offer a higher down payment for better loan terms, including no prepayment fees.

Points To Keep In Mind Before Prepaying a Loan

• Ensure you have an emergency fund to cover unexpected expenses.
• Check if there’s a lock-in period before making a prepayment. Usually, Home Loans with fixed interest rates have a prepayment fee.
• Be aware that paying your Home Loan early might affect your tax deductions.
• Evaluate your current and future financial needs.