Should You Close a Loan Early or Continue EMIs? Real Math Explained

Paying off the loan seems to be resolving the biggest liability. Many make the choice, when they can, to pay off the loan before schedule, be debt-free, and save on interest. Although a popular option, it may not be the best financial decision. Prepayment charges, tax benefits, and alternative investment options must be considered. These factors often lead to the question of whether a borrower should close loan early if finances allow or continue to pay the EMI as predecided.

This article explores the real math behind prepaying loans and continuing the EMIs, which includes a comparison of how both options impact your finances.

How Loan Interest Works

Before deciding to close loan early, it is very important for one to understand how interest is calculated.

For example, let us say one has a home loan of ₹20 lakhs with 8% annual interest for 20 years. The monthly EMI would approximately be ₹ 16,729.

This means you end up paying ₹20,14,912 in interest, and prepaying even a portion of the principal amount can save a substantial amount.

Early Loan Closure vs Continuing EMIs

To understand whether loan prepayment or foreclosure is better than continuing with regular EMIs, let’s look at a simple example.

Assume a borrower has taken a ₹20 lakh home loan at 8% interest for 20 years, with a monthly EMI of ₹ 16,729 and total repayable amount of ₹40,14,912. After 15 years of regular payment, the borrower decides to close the loan early.

By this stage, a significant portion of the interest has already been paid, but an outstanding principal still remains due to the reducing balance structure of the loan.

The borrower has two choices:

Option 1: Continue Paying EMIs Until Loan Maturity

If the borrower continues with regular EMIs for the remaining 5 years:

• EMI remains ₹16,729
• Interest continues to be paid on the outstanding principal
• The loan closes as per the original schedule

While this option avoids a large one-time outflow, the borrower continues to pay interest on the remaining balance for another five years.

Option 2: Prepay and Close the Loan Early

If the borrower chooses to prepay the remaining outstanding amount and close the loan:

• Future interest payments are eliminated.
• Total interest paid over the loan tenure reduces, reducing total borrowing cost.
• The borrower becomes debt-free earlier.

However, this option requires checking:

• Applicable prepayment or foreclosure charges
• Availability of surplus funds
• Whether the same amount could earn higher returns if invested elsewhere

Foreclosure Charges

While most of them ignore these charges, it is also important to know about them. Most of the banks levy loan foreclosure charges, which can generally be 1-5% of the principal prepaid. Let us understand with an example:

For example, let us consider one who has a personal loan of 5 Lakh at 12% interest for 5 years. The EMI is ₹11,122, and if one prepays after 2 years, a foreclosure charge will be applicable on the outstanding amount.

Tax Considerations

In this decision, borrowers should consider tax benefits. For instance:

For Home Loans

In the home loan prepayment vs investment discussion, remember, home loan interest is eligible for a deduction of up to ₹2 lakh per year under Section 24(b) for self-occupied properties, with no upper limit in case of rented or deemed-to-be-rented properties. In addition, the repayment of principal also gets a deduction up to ₹1.5 lakh under Section 80C, and a new additional interest deduction under Section 80EEA is available for eligible first-time homebuyers, subject to conditions. All these deductions reduce the effective cost of borrowing, thereby making home loans fairly tax-efficient.

For Unsecured Loans

While, like most unsecured loans, personal loan prepayment charges apply but they offer no tax benefits.

What to Do: The borrowers should compare the post-tax interest savings with the benefits they would give up before making the decision to close the loan early.

Close a Loan Early or Continue EMIs: The Better Choice?

The decision to pre-pay the loan or to go on with the EMI payments has several considerations. There is no standardised way of deciding, but the following considerations can be helpful.

Situations When Closing a Loan Earlier May Make Sense

“Should I prepay my loan?” The answer depends on multiple factors. When you should consider prepaying or repaying a loan in advance:

• Loan interest savings are higher than prepayment charges, especially in the initial years of borrowing.
• The interest rate is relatively high, like most personal loans.
• You have extra money that is not needed for liquidity.
• It does not offer major tax advantages.

Situations When Continuing EMIs is a Better Option

When should you not prepay a loan and maintain your repayment schedule? Continuing EMI may be the smarter choice when:

• The rate of interest is lower, for instance, for mortgages.
• Prepayment or foreclosure fees are quite high.
• You get tax benefits.
• Your surplus funds can earn higher post-tax returns through investments
• You would like to keep some flexibility in your monthly cash flow

Conclusion

Before deciding to close loan early or continue EMIs, one must consider interest savings, prepayment charges, and any applicable tax benefits. Different types of loans work differently, so the calculations should also be loan-specific. Moreover, using tools like a loan prepayment calculator can help compare various scenarios and make a well-informed decision.

My Mudra simplifies the process of decision-making by providing access to relevant loan information, repayment insights, and updated guidance across different loan products!

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- How to Plan Your Personal Loan Repayment Smartly?
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