Dubai: Sometimes you may face a situation where you need a little extra money. A loan comes in handy at such times. But it may occasionally happen that your financial situation turns around faster than anticipated and allows you to pay off a sizeable chunk of the loan and clear as much debt as possible.
Paying off your debt faster will help reduce the total interest charges, and this in turn means you spend less time in debt. So far so good.
However, before you walk into the bank flashing a wad of cash, familiarise yourself with some facts. It’s understandable why there’s a penalty for delayed payment, but did you know that one can be penalised for early repayment as well?
Why do providers charge early repayment fees?
If you feel a pre-payment penalty sounds counterintuitive and are wondering why no one would want all their money at one go, think of it this way – when you repay a loan early, the lender will not get the expected interest (for lenders, the interest is their profit). Hence this clause is often put in place.
So lenders are allowed to charge these fees because when you take out the loan they calculate the amount of time it’ll take you to pay back, and the interest it will charge you for doing so.
By ending the agreement early, the provider ends up with less money in its pocket so it can reclaim a little of this through early repayment charges.
It’s important you tell your provider if you are changing the amount you pay, as you generally can’t just start making larger payments to it without a penalty being charged.
The amount can vary and the practice isn’t universal. It would depend on the lender’s terms and conditions. To find out, you should read the fine print before you sign on the dotted line.
How to calculate if early repayment is worth it
Typically, if there is no pre-payment fee imposed by the lender you will benefit by repaying your loan sooner. Even if this clause is in place, you could still save some money. It would all depend on what the penalty fees are and how much of the loan you have left.
First of all, you need to determine how much you will save by paying early. You can calculate this by adding the total interest for the remaining tenure plus any ongoing fees. This final value is what you stand to save if you decide to repay your dues at present.
Subtract the pre-payment and other fees from the above amount. Pay attention to the kind of fees levied – whether flat or on a percentage basis. The remainder value is what you will save by paying your loan early. A negative figure denotes more cost than savings.
Pros and cons of early repayment
If you’re confident you can pay off your loan early, it makes sense to look for a lender who does not have a pre-payment clause. But often loans are taken without such a foresight.
However, even if a penalty is levied, pre-payment can be a good or bad decision depending on the type of loan and your outlook. Take your pick.
• Less interest translates to more money saved
• Improved credit score if you’re free of debt
• Free money to use for whatever you please – reinvesting, splurging, etc
• Opportunity to get a new loan which might offer a better rate
• Ongoing fees can be avoided
Disadvantages are as follows:
• Interest on business loans is deductible and you will lose this deduction
• You might lose a significant amount through pre-payment charges
How can I pay off a loan early?
Most people decide to pay off a loan if they have the money to do so - they’ve come into some money from an inheritance, been given a bonus at work, had a pay rise or they have enough in their savings.
If you have decided to repay a loan early, after considering the above risks and perks, and you have the means to cash in-hand, here’s how you would go about it.
You will usually need to tell your lender that you want to pay the loan off and it will provide you with an ‘early settlement amount’ which is a figure for the remaining amount of money, plus any extra charges, it needs to clear the loan.
If you agree to this amount, most lenders request that you repay it within 28 days. But if you change your mind you can continue with your regular payments.
There are many different techniques for paying off a loan early. While many people will tell you that their way is best, it’s important to choose a method that works for your budget and lifestyle.
Some effective payment methods include:
• Dividing your monthly principal (borrowed amount) and interest rate by 12, then adding that amount to your monthly payment. This adds up to 13 payments per year while eliminating the need for a large lump sum.
• Use additional money from a bonus, or other unexpected windfall to help pay down your principal.
• If paying off your loan early is a top priority, consider looking for a source of additional income that you can dedicate to your goal or a temporary cut in big purchases to fund additional loan payments
How else can I save money on a loan?
It may be possible to lower the costs of your loan through refinancing or reducing the term of the loan.
• Refinancing to a lower interest rate
Although your aim is clearing your debt and paying off your loan early, if you’re not able to do this, refinancing to a cheaper loan might be an option.
If you can find a loan with a lower interest rate, this could work out as a cheaper option for you if you don’t have the cash to clear your existing loan. Remember, early loan repayment charges may still apply to the original loan so factor those into your calculations.
• Reducing the length of the loan
It may be possible to reduce the length of time you’re paying back your loan, which should also mean you pay less interest overall. Speak to your lender and see what your options are, it may agree to shortening the loan but watch out for changes to your interest rate if it does.
Checklist: Questions to ask yourself before you pay a loan off early
If you’re trying to decide whether to put extra money toward a loan payment, ask yourself these questions:
Question #1: Do I have room in my budget for extra loan payments?
Extra loan payments can affect your budget just like any other expense. Before you start paying down a loan early, take a look at your current income and account balances.
You’ll want to avoid dipping into your savings to make extra payments, so make sure you have enough discretionary income to put toward your loan.
Question #2: Will paying off a loan early cause issues with other payment obligations?
While you can lower your loan amortisation with extra payments, don’t do so if you risk falling behind on bills or other debts.
Consider all of your loans and make sure that you can afford at least the minimum payment on these before paying off your loan early.
If another loan has a higher interest rate than your loan, it may be better to pay that one off first.
Question #3: How long do I have to pay off my loan?
Many people start paying down loans early so they can avoid paying additional interest later on. While this is a sound strategy, it’s important to consider factors such as your loan period and payment amount before making any final decisions.
For example, making small, additional payments on a 10-year loan may only shorten amortisation by a few months. In contrast, making additional payments on a 3- or 5-year loan may help you save more time and money.
A banker can help you decide whether paying off a loan early or putting your money into a savings account will be better for your financial goals.
If you think you’re being charged an unfair amount, you have the option to refuse to pay it and to continue with your loan agreement, or to complain about the charge to your provider.
You can also call the Consumer Protection Department of the Central Bank at 800 CBUAE (800 22823) for consumer complaints and enquiries. They will walk you through the process of registering a complaint and answer any questions you might have.
Many people try to pay down their loans ahead of schedule to improve their credit score, shorten their repayment timeline, or just to avoid being in debt.
But before you start applying extra payments to your loan, it’s important to review your finances and develop a payment plan that fits your budget and needs.
Before you ask how to pay off a loan early, you should take time to determine whether or not you can. If you have other debts or lots of financial obligations, it may be better to concentrate on making consistent payments on schedule rather than paying off a loan early.
Pre-payment penalty is an important factor to consider when taking a loan. Though early loan closure may not be on everyone’s radar, you never know what can happen in future.
So, take all these factors into account. However, just having the choice of being able to clear your debt early might be enough to give you peace of mind.