Prepayment

Every loan comes with a schedule that breaks the total to be repaid into equal instalments. Sometimes a borrower has extra money — a bonus, an inheritance, a maturing deposit — and wants to reduce what is owed.

Prepayment is paying back the capital before the specified time. It reduces the capital outstanding, and with it the remaining EMI period on the loan.

It is not always free. Many loans restrict prepayment for certain periods, such as 12 months, or levy charges for it — the workbook's example is a car loan. For home loans, RBI has mandated that there would be no pre-payment charges for home loans taken from banks.

What prepayment changes. Interest in an amortising loan is charged on the outstanding balance. Cutting the balance cuts every future interest charge. The EMI can then stay the same, so the loan ends sooner, or be reduced over the original remaining tenure.

Costs to plan for. Where the loan permits prepayment only after a lock-in, or charges for it, those charges come off the benefit. If an asset is sold to prepay the loan that financed it, the workbook asks the borrower to plan for pre-payment charges the bank may levy.

Prepay or invest? — section 4.14. The workbook sets out four considerations:

1. Burden. If the loan burden is a strain, paying it down may be essential for mental peace, even if it is not the best deployment.
2. Size. A small amount against a large loan makes little difference; an amount that is a significant portion of the loan can bring a debt-free position earlier.
3. Rates. Compare the loan rate with the expected return. High-cost credit card or personal loan outstanding makes repayment the better choice. The workbook's illustration: if long-term equity returns come to around 12% while the loan rate is around 7%, investing is the better idea — but the higher-earning investment carries risk, and that should not be forgotten.
4. Asset class. Equity brings extra risk into the comparison; investments compound while a loan's interest falls as it is repaid.

Windfalls are the classic trigger — the workbook suggests looking at outstanding loans and considering prepaying some of them when one arrives.

Loan terms are the workbook's own (Rs 10 lakh, 7%, 10 years, monthly rest, EMI Rs 11,610); the prepayment is illustrative.

After 24 EMIs, the outstanding principal on the loan is about Rs 8,51,627, with 96 EMIs still to go. The borrower receives a bonus and prepays Rs 1,00,000 into a bank home loan, so there is no prepayment charge. New outstanding: Rs 7,51,627.

Keeping the EMI unchanged saves roughly Rs 68,000 of interest over the remaining life of the loan for the Rs 1,00,000 prepaid.

Now apply the workbook's test. The loan costs 7%. If the borrower instead has a personal loan at 16% outstanding, that is where the Rs 1,00,000 should go first. If there is no costlier debt and the alternative is long-term equity expected to return around 12%, the workbook leans towards investing — accepting the risk that equity may not deliver it. And if the EMI is already straining the budget, lowering it to Rs 10,247 may be worth more to the household than the arithmetic suggests.

Chapter 4 (Debt Management and Loans): section 4.7.8 defines prepayment and the RBI rule on home loans; 4.3.4 uses it in debt re-scheduling; 4.2.4 links it to windfalls; 4.14 sets out invest-or-prepay. Expect a factual question on prepayment charges for bank home loans, and a scenario question comparing a loan rate with an expected investment return.

• No prepayment charges on home loans taken from banks — an RBI mandate. Other loans, such as car loans, may carry charges or a lock-in of, say, 12 months.
• Prepayment reduces the capital and the remaining EMI period. It does not reduce the interest rate.
• High-cost debt first. Card dues and personal loans are repaid before a cheap home loan with tax benefits.
• Investing can beat prepaying when the expected return is well above the loan rate — the workbook's 12% versus 7% — but only with the risk accepted.
• Prepayment is not refinancing. Prepayment uses the borrower's own money; refinancing replaces the loan with a new, cheaper one.