Planning to pay off loan before time? Here is what works in your interest

While loans allow us to enjoy things before we have the money to pay for them, they also carry an interest cost. So, when borrowers receive a bonus or any other sort of windfall, they often think of foreclosing their loans (or paying them off before their tenure ends). This decision should be made after careful consideration of the pros and cons. 

Foreclosing helps reduce financial stress. If an investment matures, or you happen to sell an asset, you may want to foreclose a loan with that money, and thereby reduce the burden of equated monthly instalments. Doing so also allows you to invest more every month towards achieving your financial goals. 

“Foreclosing allows you to save on interest cost. It can be especially helpful in case of costlier loans like personal and credit card loans,” says Naveen Kukreja, chief executive officer (CEO) and co-founder, Paisabazaar.com. 

Borrowers should consider foreclosing if they foresee income uncertainty. Says Vishal Dhawan, founder and CEO, Plan Ahead Wealth Advisors: “Consider foreclosing, if alternative investment opportunities are likely to yield less than the cost of the loan.”

Once you have decided to foreclose, make a list of all your loans along with the rate of interest you pay on them. Repay the highest-cost loan first. “Unsecured loans like credit card debt and personal loans are typically more expensive and should be paid off first,” says Dhawan.

Foreclosing unsecured loans has a salutary effect on the borrower’s credit score. “Credit bureaus give higher credit scores to those who have a higher proportion of secured loans in their loan portfolios,” says Kukreja.     

Foreclosing a loan other than floating-rate home loan attracts foreclosure charges, which can range between 2 per cent and 6 per cent. Take this cost into consideration when making the decision. Moreover, home loans offer tax benefits on both principal (Section 80) and interest (Section 24). 

Foreclosing a home loan can distort your tax planning. If you have two loans that charge the same rate of interest, prepay the one that does not give any other benefit. Businesspersons should close a loan without overdraft facility rather than the one with the facility — other factors remaining the same.

Dhawan says one must take into consideration where one stands in the loan tenure. “In reducing balance loans, more interest is paid early in the loan tenure rather than later, so it is more beneficial when you prepay in the early part of the tenure,” says Dhawan. 

In some situations, foreclosing a loan may not be beneficial. Kukreja advises borrowers to ensure they have sufficient funds at their disposal. Prepayment should not lead to depletion of emergency funds or of investments set aside for meeting short-term financial goals. “The borrower should not be forced into taking costlier loans to deal with financial exigencies or short-term goals arising after the foreclosure,” says Kukreja. Fixed-rate loans come with pre-payment charges. “Ensure that the cost of foreclosing the loan does not exceed the benefit in terms of saving on interest cost,” he adds.

The return that your investment can generate should also be considered. Home-loan borrowers, who invest in equities, might be better off investing in the markets rather than making prepayments. Over the long term, equities or equity funds are likely to generate higher returns than the interest charge on the home loan. 

Finally, instead of foreclosing, a borrower can exercise the option of transferring her home loan to another lender who charges a lower rate. While doing so, she should ensure the interest cost saved is significantly higher than the cost of transferring the home loan.