Prepayment is simply a facility provided by banks or lending institutions to close the loan earlier than planned. Banks write penalties for early closure of loans to protect themselves against the loss of interest that would have been paid by the borrower over time. The prepayment penalty is added as a way to recoup the cost of loan management.
Small Pending Amount
Borrowers choose to pay off the loan when the principal amount left is small and the borrower wants to save whatever interest he/she can save by paying off the loan early.
Banks set up a lock in period in their loan contracts during which time borrowers cannot pay off the loan. After this is completed, borrowers can opt for a prepayment.
Prepayment can occur if the borrower decides to switch banks to gain benefits of a lower interest rate at the other bank. Most times personal loans carry high interest rates and these force borrowers to switch banks to refinance their loans at a lesser rate of interest.
Post availing a loan, an increase in salary or a windfall received may lead to an income increase and encourage the borrower to close off the loan ahead of tenure.
Terms of Contract
Ensure you read the small print in a loan contract. Discuss all points that concern you, including the difference in charges between paying the loan off via the borrower’s own sources and refinancing from another bank.