Jun 22, 2012 04:59 PM IST | Source: personalfn.com

Home loan: To prepay or not to prepay?

As in any interest rate scenario, many people who have home loans are considering whether or not it is recommended to prepay their home loans so as to incur lower EMI payments going forward.

Home loan: To prepay or not to prepay?

By Personal FN

As in any interest rate scenario, many people who have home loans are considering whether or not it is recommended to prepay their home loans so as to incur lower EMI payments going forward.

But before rushing into the decision, there are a few things to look into when considering home loan prepayment, and these are explained below:

1. Prepayment & Interest Savings

First, what is prepayment? Prepayment is when you decide to pay an additional (over and above your regular EMIs) amount of principal of your loan back, ahead of time. This reduces the principal outstanding, which in turn reduces your EMIs or your remaining loan tenure.

Banks typically levy a prepayment charge of about 2 - 3% of the outstanding loan amount, if you prepay above a certain amount, or if you are switching lenders. However as per recent NHB notification, this has been disallowed going forward. There are still some loans on which prepayment charges apply, so be sure to check with your lender.

At the very least, most banks will allow part prepayment up to a certain limit without levying on you any prepayment charge.
In some cases like with SBI, if the prepayment is out of your own income and not borrowed money, you can prepay any amount without incurring any penalty. You can opt to partly prepay your loan regularly, for example every 3 months, constantly reducing your principal outstanding, bringing down the amount of interest you will owe the bank. Remember, the longer the tenure of the loan, the more the interest you are paying, so part prepayments are a good way of saving on interest payments.

An illustration will help explain the point:

Our favourite fictional character, Mr. Shah has taken a loan 5 years ago, and wants to reduce his debt burden by making part prepayments.

Initial Loan Taken Rs. 20 lakh
Tenure of Loan 20 years
Loan tenure elapsed 5 years
Current EMI Rs. 22,022
Current interest rate 12% p.a.

 

 

 

 

 

If Mr. Shah were to continue with his EMIs, he would repay the following amounts:

Total interest payment (nominal value) Rs. 21.29 lakhs
Total Principal Repaid (outstanding principal) Rs. 18.35 lakhs

 

 

 

 

(These figures can be arrived at from the amortization table in his loan policy document which his bank has to provide to him.)

Thus, his Rs. 20 lakh loan would cost him approximately Rs. 40 lakh over 20 years, assuming a constant interest rate of 12% for the sake of calculations.
Understandably, Mr. Shah wants to reduce the debt burden.

He can save enough through the year by cutting down his expenses and channelizing his bonus towards home loan prepayments, to pay an additional 3 EMIs every year.

If he does so his payments come down to:

Total interest payment (nominal value) Rs. 12.03 lakhs
Total Principal Repaid (outstanding principal) Rs. 18.35 lakhs

 

 

 

 

He saves approximately Rs. 9 lakhs in interest payments - Certainly a tidy sum!

Also remember, any prepayments towards home loan will be considered for tax benefit under Section 80C as they are repayment of principal of the home loan - an added benefit!

Additionally, by doing so, he would not incur any prepayment penalty as this is below the maximum penalty incurring limit levied by his bank, and he can reduce his loan tenure by close to 6 years. He can repay his total loan in approximately 14 years instead of 20.

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But, in case you are prepaying above the penalty free limit and the bank is levying a prepayment charge on you, there are two things to keep in mind:

a. Negotiate

Prepayment charges are not necessarily final - you can negotiate with your bank and if you have good credit history they may reduce or even waive the prepayment fee. If your loan has a lower interest rate than the current rate of interest (if you have taken a fixed home loan) then banks would be more open to letting you prepay and waiving the fee. Also note, in some cases, if you are prepaying out of your own savings rather than switching lenders, then there might be no prepayment charge applicable, provided it has been more than 3 years since you have taken the loan.


b. Calculate

Do check your loan amortization table to see how much interest you will be saving by prepaying your loan, and compare this to the prepayment charge you will have to face. If interest saved is greater than the prepayment penalty, you can consider prepaying your loan. You will probably find that the savings on interest payments are so large compared to prepayment penalty, that it makes more sense to prepay.

2. Opportunity Cost

Suppose, instead of prepaying your loan with additional lump sums or a higher EMI, you were to invest the money into an equity mutual fund (provided this is suitable to your risk appetite and goal time horizon) and let it earn returns over the years.
Which one would be more beneficial to you?

Let`s continue with the above illustration:

Mr. Shah's current EMI is Rs. 22,022.
He has 15 years left on the loan, at 12% interest.
If he increases his payments by prepaying approximately additional Rs. 66,000 per year i.e. Rs. 5,500 per month, he saves Rs. 9 lakhs in interest and pays his entire loan off in 14 years total i.e. 9 years more.

He can avail tax benefits under Section 80C up to Rs. 1 lakh p.a. on the prepayments (assuming the entire Section 80C limit is available).
He can also avail tax benefit up to Rs. 1,50,000 p.a. (provided the house is self occupied) under Section 24 on the interest repayments.
This is a sure fact - there is no market related risk involved here.

However, instead of doing this, suppose he invests the Rs. 5,500 per month into an equity mutual fund for 9 years.
Assuming a 15% rate of return on equity, his SIP of Rs. 5,500 would earn him approximately Rs. 12.58 lakhs.
This is dependent on the equity rate of return and does involve risk.
Currently long term gains on equity are not taxable, and so there is no tax burden on this option.

Here, it would make more sense for Mr. Shah to invest the money rather than channelizing it towards prepayments. This is because the assumed return on equity (15% p.a.) is higher than the interest rate on the loan (12% p.a.).

If Mr. Shah had a short term investment horizon and a lower risk appetite, he would invest in debt rather than equity, earn a lower post tax rate of interest on the debt investment than he would be paying on the home loan, and thus it would make more sense for him to prepay the loan.

3. Other Points to Note:


a. Before prepaying any loan, make sure you have enough funds left aside to meet any emergency needs that might arise


b. It is a myth that prepayment is only beneficial in the initial years of the loan. When you prepay you are prepaying principal and reducing the interest burden. This is beneficial at all points in the loan tenure - only more so in the beginning.


c. If you have more than one loan, prepay the high interest rate loan first.

d. Often, a question people ask when considering prepaying the home loan is to do with tax benefits. But remember that it is better to earn more and pay more tax than earn less just to pay less tax. When prepaying a home loan, there are only two things you should keep in mind:
- Interest Saving on prepayment
- Opportunity Cost

However remember, this advice is general. If you are seeking a financial plan or have any queries on your home loan, feel free to call us at (022) 6136 1200. When dealing with a home loan or any major liability, please consult your Financial Planner for specific advice.
When dealing with any liability, it is also advisable to stay within certain recommended personal finance guidelines. For example, a thumb rule is that your total monthly EMI of any and all loans that you have should not be more than 35% of your monthly take home salary. Do keep this in mind when opting for a home loan in the first place.

PersonalFN is a Mumbai based Financial Planning and Mutual Fund Research Firm.

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