Prepayment is a facility provided to the loan holders to clear the loan prior to the scheduled repayment period, be it partially or completely. Usually, when there are excess funds with the loan holders they tend to opt for a pre-payment facility.
The main reason one opts for a loan pre-payment facility is to reduce the amount of interest paid on a loan. Irrespective of low/high the interest rate can be, an additional amount paid apart from the regular EMI can always save a considerable amount on the total interest amount.
Let us consider a scenario if you’ve taken a loan of AED 100,000 for an interest rate of 8% for a tenure of 10 years. A loan for 10 years will make you end up paying an interest amount of around AED 45000 which is 45% of the loan amount borrowed.
The interest rate amount can go even higher if the repayment period is more which mostly happens in the case of a home loan where the repayment period is up to 25 years.
In order to save money on the interest rate, a pre-payment facility would help the borrower.
Considering the above scenario, if the loan holder makes a pre-payment of AED 5000 say in the 10th month of the loan period. The outstanding loan amount in the 9th month would be AED 94947 and when reduced by 5000, the outstanding would become AED 89367.
Usually, in the initial days of a loan, the interest rate would take a maximum portion of the EMI amount. In our scenario, the EMI to be paid would be AED 1213 where interest amount is AED 667 and the principal amount paid is AED 547, going further in the 17th or 18th month of the loan tenure, this proportion will be changed that is the principal amount will take a higher portion in the EMI.
But when a pre-payment is made in the 10th month itself, the principal amount will start taking a maximum share in the EMIs paid further. So when the interest amount is reduced the principal amount will get higher and ultimately leads to savings of AED 5132 (as per our scenario). These interest amount savings would get even higher when more pre-payments are made starting early.
One thing to be noted while making an extra payment would be the pre-payment fee. Banks in the UAE charge about 1% of the payment amount as the pre-settlement fee. Though some of the banks offer a free pre-settlement option once or twice a year on the loan, the loan holder must also consider this component.
So as per our scenario, 1% of AED 5000 is AED 50, which is quite less than the savings made on the interest rate. Increasing the pre-payments will definitely increase the fee charged but on the other hand, it would increase the interest amount savings parallelly.
As said earlier these savings can get even higher if the pre-payment amount is more or frequent pre-payments are made. To check how much you can save on higher/frequent payments you can use the pre-payment calculator and determine your savings.