Factors to consider prior to repayment of loan

Factors to consider prior to repayment of loan

Did you avail a loan to take care of your immediate financial requirements? Or a loan to tide you over in an emergency? If the answer is yes and living debt-free sounds good, you are probably going to consider repaying the loan before the tenure is up. Although this might sound tempting, put together the pros and cons of doing so before you make the decision since it has the potential to impact your CIBIL score as well.

So what all are the factors to be considered prior to repayment of loan?

Interest rate – This is one of the most important factors to take into account and while a high rate of interest may seem to be a sound reason to pay off the loan early, take a step back and think. Remember that certain loans such as housing loans offer you a tax deduction and hence closing the loan in entirety may not be prudent. Instead, work with your housing finance company to restructure your loan and thereby reduce your interest burden.

Penalty or prepayment fee – If you choose to repay a loan before completion of the tenure, do check whether any prepayment charges would be applicable. This adds to the total cost of the loan and is typically represented as a percentage of the total outstanding loan amount.

If this fee when translated into rupee terms is high, keep in mind that repaying the loan especially if it is towards the end of the tenure may not be a prudent decision.

Stage in the loan tenure – Banks and financial institutions typically structure a loan such that you first start repaying the interest and then the principal amount. Hence if you have just availed of the loan, repaying at this stage works better as you have not paid too much by way of interest. However this is not the case towards the end of the loan tenure, as you would have paid off most of the interest and the principal amount would need to be repaid in any case.

Availing another loan – If closing an existing loan means that you will be offered a fresh loan at better terms, especially when it comes to interest rates, it is a good enough reason to evaluate the offer. Once you have debt outstanding against your name, it is more difficult to get further loans, especially if your debt-to-equity ratio is high.

Other financial obligations – Do you have a loan standing debt on a credit card, or a personal loan at a high rate of interest? It may just be worth your while to consider paying off such loans before approaching a loan that has a lower interest rate or tenure. One such case would be to weigh paying off a home loan versus a high interest credit card outstanding.

Liquidity requirement – If repaying your loan means delving into your nest egg or contingency funds, you may want to reconsider the plan. It would probably be wiser to continue with the current loan rather than utilising your savings to pay it off.

Having liquidity or cash in hand in the case of an emergency or to meet monthly expenses is important and closing a loan at the cost of this liquidity needs serious thought, and is not the most practical move.

Evaluate your goals – If the idea of a debt-free life is what appeals the most, then it is likely that any other goals you may have will take a backseat. For instance, do you plan to set up a small business or travel to a long dreamt-of destination? If yes, then utilising funds saved up for this purpose to repay existing debt may not be a solution.

Consider your short- and long-term goals and prioritise them. If by paying off debt early you would need to compromise on them even if they are important goals, you may want to reconsider making the payment.

Life stage – The life stage that you are at also determines to a large extent your inclination to prepay a loan. For example, someone close to retirement may choose to pay off all existing debt at the earliest rather than struggle with it in their twilight years with possibly no stable source of income to make loan payments.

Your risk tolerance and time horizon are also factors to be considered when deciding whether to repay a loan.

In conclusion

As you weigh the options available to you, do put careful thought into the same. Ensure that not only do you keep your expectations real but also have a clear plan in place to achieve your objectives.

Remember that paying off debt in a timely manner has an impact on your credit score, which in turn is critical in order to maintain your creditworthiness. If you fail to repay a loan for whatever reason, your credit score is very likely to take a nosedive. If you believe that credit counselling is what you require, consider availing of the services of a credit health management company. Over a period of time you can look to improve CiBil score and enhance it as well.