Prepayment Strategies: Enhancing Your EMI Experience

Remaining debt-ridden for most of our lives isn’t a pleasant experience. However, in today’s world, where we prefer convenience over moderation, combined with the rising cost of living, it is almost inevitable that we apply for a loan. Whether you wish to fund your education, cover the costs involved in a marriage, purchase a new car, or pay for a new house—you rely on loans from banks and NBFCs.

Financial institutions have also introduced new services to better cater to the varying customer demands. When you apply for a loan, the lending institution provides you with several options in terms of EMI, interest rate, and repayment period. The interest rate depends on your credit health and repayment history, while you can select the EMI and tenure options. It can be for something as simple as purchasing a gadget from an online marketplace or a milestone in your personal life, such as buying a new car or a house.

If you have taken a substantial loan, you must make EMI payments over several years. Your EMI consists of two components—principal amount and interest. The principal amount is the loan amount you take from the lending institution, while the interest is the additional amount you pay to the lender for the privilege of availing of the loan. However, when you take a large loan, the total interest accumulated over the tenure period can be substantial. To reduce this burden, you can opt for prepayment.

What is prepayment and how does it work

Prepayment is the additional amount (on top of EMIs) you pay to reduce the EMI or tenure (or both). You can make a single, lump sum prepayment or several partial prepayments during the loan duration. By making partial prepayments, you reduce the loan principal, resulting in interest savings over the remaining repayment period.

Let us consider an example to understand this better. Let us assume Mr. X took a loan of Rs. 40 lakhs to purchase a new car with a repayment duration of 6 years and an interest of 8% p.a. This means he has to pay Rs. 70,133 as EMI every month, with the total interest amounting to Rs. 10,49,573 over the tenure period. You can use any online EMI calculator to calculate the EMI, total interest amount, and the total amount you repay over the loan tenure.

Now, Mr. X has received a significant windfall and plans to make partial prepayments to reduce the loan principal. The partial prepayments are as follows:

Instalment 1: Rs. 3,00,000

Instalment 2: Rs. 3,00,000

Instalment 3: Rs. 4,00,000

The EMI amount reduces from Rs. 70,133 to Rs. 52,292, while the savings on interest is Rs. 2,59,513! 

Alternatively, Mr. X can keep paying the same EMI and reduce the tenure from 72 months to just 51 months. This translates to savings on interest of Rs. 4,95,863!

Prepayment strategies

Let us now look at a few prepayment strategies to reduce your loan EMI burden:

• Utilise windfalls wisely

Whether you receive a one-time lump sum payment (like inheritance) or a pay hike, you must utilise the extra money wisely. Using such funds strategically can help you reduce the loan principal and the overall interest burden. This, in turn, will allow you to pay off the loan faster.

• Choose to make partial prepayments

You can either make a one-time significant prepayment or several partial prepayments. Choosing the latter will allow you to plan your finances and use some amount to make informed investment decisions.

• Talk to the lender

Negotiating with the lender to evaluate prepayment options and associated charges can help you reduce the overall prepayment costs. If you have a good track record, the lender may agree to offer discounts on prepayment charges.

• Consider refinancing for more favourable terms

If you feel you are paying high interest rates or find another lender offering more favourable terms, you must consider refinancing with the new lender. This reduces your interest costs and lets you choose favourable prepayment options without additional or excessive charges.

Conclusion

Opting for loan prepayment allows you to reduce the overall loan principal, thereby offering significant savings on the total interest. If you receive a significant windfall or a pay raise, you can channel the additional funds towards loan prepayment. By opting for the right prepayment strategy, you can reduce your debt burden and maximise savings on the loan interest.