Prepayment vs Foreclosure of Loans: What Is the Difference?

How you repay your loan can make or break your credit score, which is a crucial factor in determining your creditworthiness. Many borrowers prefer to repay their loans throughout the entire loan tenure, while others prefer to clear the loans as early as possible by opting for prepayment or foreclosure of loans. Borrowers often choose to prepay or foreclose the loans or pay throughout the loan tenure without completely understanding these terms and end up paying extra fees and charges. Hence, to make sure you make an informed decision when planning your loan repayment, you must understand the benefits and other important things of prepayment and foreclosure of loans.

What is Prepayment of Loan?

If you have any surplus funds, you can use them to prepay your existing loans and reduce your debt burden. Loan prepayment is a facility offered by banks and other financial institutions (lenders) that allows you to repay your loan before the end of the loan term. Prepayment of the Loan can be done either in part or full. It helps you reduce your outstanding loan amount, thus resulting in a reduced interest outgo and decreased loan tenure. Many borrowers, who get surplus cash in the form of a bonus, incentives, profit, etc., choose to prepay as much loan amount as possible to get rid of the debt faster. As you might already know, the interest is calculated based on daily reducing balance and EMIs are adjusted based on the latest outstanding amount in the loan account. Depending upon the outstanding loan amount, this can make a considerable difference in the total interest outgo and loan tenure.

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What is Foreclosure of a Loan?

As the name suggests, Foreclosure of a Loan is a legal process where the borrower repays the complete outstanding loan amount before the end of the loan tenure. Foreclosure significantly reduces your interest outgo and makes you get rid of debt. Typically, financial institutions allow foreclosure after completing a certain period, which varies across the types of loans and lenders. If your loan is eligible for foreclosure, you can submit the application for the foreclosure of a loan to your lender, who will give you a quote after considering your outstanding amount, remaining loan tenure, and the interest paid. Once approved, you can pay the required amount for loan foreclosure and get back your original documents and No Objection Certificate (NOC) from the lender.

What are the benefits of opting for Prepayment or Foreclosure of a Loan?

Whether you decide to opt for a prepayment of a loan or foreclosure of a loan, as a borrower, it will help you in the long run if the decision is taken after analysing all the aspects of it. Here are some of the benefits of opting for a prepayment or foreclosure of a loan:

1. Helps Reduce Your Debt Burden:

If you have a huge debt or find yourself in a challenging debt trap situation, there is no better way to get rid of the debt by opting for a prepay or foreclosure. If you have any surplus savings or an investment that is not generating the expected returns, it is best to use it to reduce your debt burden. Even if you do not have any surplus savings, simply repaying more than your fixed EMI can help you become debt-free sooner.

2. Saves Total Interest Outgo:

While the percentage of the interest rate may seem tiny, the longer the loan tenure, the more interest you will end up paying. Home loan borrowers who take the loan for a longer tenure of 20 to 30 years end up paying almost double or even more interest than the principal amount. Opting for a prepayment or foreclosure of a loan in the initial or middle stage of your loan tenure can help you save a substantial interest outgo. However, it is advisable to do a cost-benefit analysis before opting for a loan prepayment or foreclosure in the later stage of your life as it can make you pay more on the pre-closure charges than what you would save on the interest.

3. Reduces the Loan Tenure:

Foreclosure of a loan is legally ending the contract between you as a borrower and the lender before the loan tenure ends. This eliminates your liabilities towards the loan completely. By opting for a part-payment, you can either lower your EMI amount by keeping the loan tenure as it is or reduce your loan tenure by keeping the EMI amount constant.

4. Helps You Maintain the Credit Score:

Prepayment or foreclosure of a loan does not affect your credit score. The credit bureaus and lenders consider prepayment and foreclosure as a loan paid within a set tenure. However, if you had never opted for any loans in the past and want to build your credit history, paying your dues regularly for a longer duration will help in improving your credit score and credit history.

5. Ensures the Best Use of Surplus Money:

We often get tempted to splurge our surplus income and savings on things we might not even need. For example, one of my friends recently bought an expensive smartphone with his annual bonus while he is struggling to repay his home loan. Controlling the urge to splurge and using the surplus sum to prepay the existing loans will instil financial discipline and help you become debt-free while saving your total interest outgo.

6. Offers Tax Benefits:

If you have a home loan and you decide to prepay it, it can offer you tax benefits. Any prepayment of a loan done over and above your EMI amount is considered as repayment of the principal. Hence, the prepayment amount becomes eligible for tax deduction under Section 80C of the Income Tax Act.

What are the things you must consider when opting for a Prepayment or Foreclosure of a Loan?

1. Prepayment And Foreclosure Charges:

Certain loans, like personal loans, carry very high-interest rates. Even if the interest rates of home loans, education loans, loans against property, etc., are comparatively lower, these are large-amount loans that increase the borrower's total interest outgo. Hence, prepayment and foreclosure are common practices amongst borrowers to reduce their interest outgo. Although loan repayment is a freeing experience, banks and other financial institutions charge up to 5% of the total outstanding amount as a pre-closure fee, which might not offer many benefits to the borrower, especially when the pre-closure is done at a later stage of the loan tenure. Therefore, it is advisable to check for the prepayment and foreclosure charges and terms before availing of a loan.

2. Investment Options:

Before directly opting for a foreclosure or prepayment, you should explore investment options that can offer better benefits. For example, if the equity or mutual fund investment has a better potential to grow, you can consider investing your surplus funds in equity or related instruments to generate higher returns. However, if you are not confident about the potential returns, it makes sense to use the surplus amount for pre-closure.

3. Limited Tax Benefits:

While the prepayment offers a tax deduction, it is necessary to understand that you can claim a maximum of Rs 1.5 lakhs towards the principal payment of a home loan under Section 80C and Rs 2 lakhs towards the interest payment of a home loan under Section 24(b). Any payments above this limit may not offer you any tax benefits.

To conclude:

Due to the increased competition, many banks and NBFCs are offering several types of loans at attractive interest rates and loan terms. Many individuals avail of these loans because they get a good loan deal. However, most borrowers later feel the burden of hefty EMIs and try to find ways to get rid of the debt. Prepayment and foreclosure are the best options to reduce your debt burden faster and live a debt-free life. However, before opting for foreclosure or prepayment of a loan, it is advisable to check the loan terms and related charges and make an informed decision.

Warm Regards,
Ketki Jadhav
Content Writer