Part payment sounds like a straightforward good idea. You have extra money, you put it towards your loan, you save on interest. Done.

But it is not always that simple. There are situations where making a part payment is genuinely the best thing you can do with that money. And there are situations where it is not. Situations where your money would work harder somewhere else, or where making that payment could actually put you in a worse position.

This article is about telling the difference.

When You Should Absolutely Make a Part Payment

Your loan is in its early years

The interest calculation on most loans works on a reducing balance method. Which means every month, interest is charged on whatever principal is still outstanding. The earlier you reduce that outstanding amount, the more months of compounding interest you cut off.

If your loan has 4 years left and you pay Rs. 1,00,000 now, that reduction works for 48 months. If your loan has 8 months left, the same Rs. 1,00,000 only has 8 months to make a difference. Early payments carry much more weight.

Do it

You are in the first half of your loan tenure and you have surplus funds sitting idle. Making a part payment here almost always beats leaving money in a savings account or fixed deposit. Your your loan interest rate is likely higher than what any FD will give you.

Your loan interest rate is high

Personal loans and credit card EMIs typically charge between 14 and 24 percent per year. If you have money sitting in a savings account earning 3.5 percent or even an FD at 7 percent, and your loan is charging you 18 percent, the math is not a debate. Pay down the loan.

Every rupee you reduce from a high interest loan effectively gives you an 18 percent guaranteed return. That is something no investment is going to match at the same level of risk.

Do it

Your loan interest rate is higher than what you are earning on your savings or investments. This is the clearest case for making a part payment as soon as you have the funds.

You want to reduce your monthly obligation

If you are expecting a change in income, say a career switch or starting something on your own, and cash flow might tighten, reducing your EMI now through a part payment gives you breathing room later. You pay more now when you can, and owe less every month when it matters.

When You Should Not Make a Part Payment

You have no emergency fund

This is the most common mistake. Someone gets a bonus, puts the entire amount into their loan to save interest, and then two months later their car breaks down or there is a medical expense. Now they are taking a personal loan at 18 percent to cover it. That personal loan charges more than what they were saving on the original one.

Before you make any part payment, make sure you have at least 3 to 6 months of your monthly expenses kept aside in liquid form. That money should not be touched. Once that cushion exists, whatever is left is fair game for a part payment.

Putting all your surplus into a loan and leaving yourself with no buffer is a financial risk. Life does not announce emergencies in advance.

You have higher interest debt elsewhere

If you have a home loan at 8.5 percent and a credit card outstanding at 36 percent, pay off the credit card first. Always tackle the highest interest debt before anything else.

It sounds obvious but many people default to paying extra on their biggest loan by amount rather than by interest rate. The amount is just a number. The rate is what determines how fast your debt is growing.

Think about it this way

Home loan outstanding: Rs. 25,00,000 at 8.5%

Credit card outstanding: Rs. 80,000 at 36%

The credit card balance is growing at Rs. 2,400 per month in interest alone.

The home loan, despite being much larger, costs you proportionally far less per rupee outstanding.

Clear the credit card first. Every time.

Your loan is nearing its end

In the final months of a loan, almost your entire EMI is principal repayment with very little interest. The interest burden is already minimal. Making a large part payment at this stage saves you almost nothing compared to the same payment made 3 years ago.

If your loan has less than 6 to 8 months left, just let the regular EMIs finish it. Your money is better off elsewhere at that point.

Skip it

You are in the last 10 to 15 percent of your loan tenure. The interest remaining is small. Putting that lump sum into a liquid investment or your emergency fund will serve you better at this stage.

A prepayment penalty eats your savings

Some fixed rate loans charge a penalty for early repayment, typically 2 to 4 percent of the amount you are paying ahead of schedule. Before you make a part payment, check your loan agreement.

If the penalty is 3 percent and you were planning to save 2 percent in interest, you are actually losing money on the transaction. Run the numbers first. Your bank's customer care or loan statement will tell you the prepayment terms.

You have a tax benefit on the loan

Home loan interest up to Rs. 2,00,000 per year is tax deductible under Section 24 if you are repaying an active home loan. If you are in the 30 percent tax bracket, that deduction saves you up to Rs. 60,000 in taxes each year.

This does not mean you should never make part payments on a home loan. But it does mean the effective cost of your home loan is lower than the stated interest rate once you account for the tax savings. Factor that in before comparing against other uses of your money.

A Simple Way to Decide

Before making a part payment, check these in order

1. Do you have 3 to 6 months of expenses as an emergency fund? If no, build that first.
2. Do you have any debt with a higher interest rate than this loan? If yes, pay that down first.
3. Is your loan in its final few months? If yes, let it finish normally.
4. Does your loan have a prepayment penalty? Calculate if the savings outweigh the fee.
5. If all of the above are clear, go ahead and make the part payment. You will come out ahead.
The goal is not to pay off debt as fast as possible. The goal is to get the best outcome from the money you have. Sometimes that means making a part payment. Sometimes it means keeping that money liquid. The checklist above helps you figure out which one applies to your situation right now.

If you have not yet read about how much a part payment can actually save you, the previous article covers that with real numbers.