If you’ve got a good bonus and have some loans ongoing, the first thing that possibly comes to your mind is to pay off the loans and any other high-cost debts. But that isn’t a straight forward decision as it may seem. There are a few points that you need to keep in mind before deciding to foreclose a loan using any surplus cash.

The first question that needs answering is the cost of the loan and the average return on your investment portfolio. Let us understand this with an example. Ms A is a conservative investor and has parked most of her surplus funds in fixed-return instruments. Her investment corpus fetches her an average pre-tax return of, say, 8 per cent. She has a home-loan outstanding to the tune of ₹30 lakh on which she pays an annual interest of 9 per cent.

Given that her cost of loan of 9 per cent is higher than the interest on his investment, she may be better off paying of her loan/debt as and when he has some surplus money, unless she plans to invest in a different asset class such as equity which can fetch him a return higher than the interest on her loan.

Alternatively, if A is an aggressive investor who has invested in other higher return-bearing asset classes and earns an average return of 12 per cent, then she should consider investing the additional surplus, as she can generate higher returns by investing, and use the proceeds to pay her loan interest.

Foreclosure charges

Second, there may be a cost attached to paying off a loan early. Banks typically charge a penal interest if you want to pre-close your loan; this is called foreclosure charges.

The foreclosure charges vary across loan products and financiers (banks and non-banking finance companies).

According to a directive issued by the RBI, banks cannot charge a pre-payment penalty on home loans that have a floating interest rate. However, if you have a fixed-interest-rate home loan, you may have to pay prepayment charges. For instance, ICICI Bank charges 2 per cent on the residual principal for prepayment of a fixed-interest home loan.

In case of a personal loan, the pre-closure charges can be a bit high. While private banks and NBFCs charge you for pre-payment, public sector banks such as State Bank of India do not.

Citibank, for instance, charges 3 per cent for a personal loan; HDFC Bank charges 4 per cent. NBFCs such as Capital First charge 5 per cent for pre-closure.

The rates for part-payment of a personal loan also vary across banks. For instance, HDFC Bank allows part-payments only after completion of 12 months. For part payments from 13 to 24 months, a fee of 4 per cent is applicable on the part-payment amount. If you wish to make the payment from 25 to 36 months, the applicable interest rate is 3 per cent. In case you want to make part-payment 36 months after getting the loan, you will have to pay 2 per cent of the amount being repaid as pre-payment charge.

Also, banks restrict the number of times you can part-pay in a given year. HDFC Bank for instance, limits it to two per year.

While, it is prudent to pay off liabilities early, pay attention to the penal interest and your investment return before you go ahead and foreclose your loan. Also, keep in mind the foreclosure charges while zeroing down on your lender; this can help you pay off your loans without causing a big hit to your pocket.

The writer is an independent financial consultant

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