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loan prepayment
Below are some factors which one should consider and work in reducing the debt exposure.
1. Type of loan:
Depending on the productivity a loan brings in your personal finance, these are categorized into 2 parts – Good loans and bad loans.
Any loan taken just to spend on personal consumption is called as bad loan. These loans generally come under unsecured category i.e. you don't need to show any collateral and also will not require a guarantor. These loans are purely disbursed based on your earning potential and repayment capacity like personal loans, credit card loans.
Good loans results in creation of some productive assets like home, intellectual capital etc. Home loans and education loans comes under this category.
There are some "not so good loans", which are taken against collateral with a specific purpose like for business expansion or personal emergency for e.g. Loan against property or gold loans.
The last category is of "Not so bad loans", which though results in creation of assets but those assets are unproductive and depreciable like Vehicle loan, Consumer durables loan etc.
While deciding on which loan to close first, the first factor you have to look at is the loan type and its impact on overall personal finance. Do note that where bad loans does not result in creation of any asset, it also is looked down upon by credit scoring agencies, so you have to start with Bad loans first. One needs to stay off bad loans as much as possible.
2. Interest rates and Tenure of Loan
People tend to prepay those loans which are near completion or paying high EMIs on. They ignore the interest outgo part. Interest portion of the EMI is the cost of the loan which you are paying. So, you need to have an understanding of what savings you'll generate out of pre paying the loan.
Interest rates on bad loans as discussed above, range as high as 16%-36%. So, technically, it makes sense to close these loans first. But tenure of loan also plays a major role in decision making towards pre closure of loan.
It is true that higher the rate of interest, higher the outflow as the interest payout would be higher for the same level of loan. So sometimes it doesn't make sense to repay the loan in the later years of its tenure. Let's understand this with an example of Rahul.
Out of his multiple loans, two loans- personal loan and car loan were taken simultaneously, as detailed below
Personal Loan (5 lakh) – Tenure 5 years, Interest rate 14%, EMI = Rs 11634/-.
Car Loan (7 lakh) – Tenure 7 years, Interest rate 10%, EMI = Rs 11621/-
| Year | Interest Out go (PL) | Interest outgo (CL) | ||||
| 1 | 65355 | 66727 | ||||
| 2 | 54265 | 59111 | ||||
| 3 | 41520 | 50699 | ||||
| 4 | 26871 | 41405 | ||||
| 5 | 10034 | 31138 | ||||
| 6 | 19796 | |||||
| 7 | 7266 | |||||
The above calculation clearly shows that if one has to close any among both, one should work on car loan first, as it will result in more interest saving.
3. EMI outgo :
EMI impacts your cash flow. High EMIs mean lower surpluses left for other savings. Loans are not only a financial burden but a psychological one too. Doing away with high EMI loans usually generates confidence in one's finances. Thus, if your high EMIs are keeping you awake at night, it is better to close those loans first. Living a stress free life is priceless.
4. Tax benefits:
There are some loan options which come with tax benefits too. Needless to say those come under good loans category. You get tax benefit u/s 80C and U/s 24 in case of home loan repayment, and in case of education loan you enjoy tax benefit u/s 80E as deduction of interest payment from tax payable income.
These tax benefits indirectly reduces the overall impact on cash outflow .So if you have such loans in your portfolio, do consider these tax benefits too, before taking a decision on which loan to prepay first.
Both Rahul and Sunita were very happy that now they have a direction and handholding on how things are to be sorted out. Rahul promised not to indulge in any kind of debt in future and Sunita took responsibility for budgeting and sticking to it, so they may come out of this trap at the earliest.
Many times one cannot escape taking loans, especially with the housing becoming unaffordable and with rising education costs. But taking loans on unnecessary consumer durables or for personal consumption worsens the personal finances. Your loan taking decision should not only depend on your present desires but also your future goals. To make your present perfect, you should not make your future tense.
Service your loan EMIs on time, don't take loans for consumption or your desires, take good loans if at all required. Your loan portfolio should not compromise your future!
For further information contact Prajna Capital on 94 8300 8300 by leaving a missed call
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