The large size and long tenure of home loans often cause its interest cost to exceed the loan principal. Now, the desire to reduce the high interest cost lead many home loan borrowers to make partial prepayments during the loan tenure. As home loans are usually lent on floating interest rates, making prepayments do not result in penalties. However, home loan borrowers need to consider some factors before making prepayments so as to derive an optimum value from them.
Choosing between EMIs and tenure reductions
Home loan borrowers have two options of prepayment to choose from – either reduce their EMIs (equated monthly instalments) or their loan tenure. While a reduction in the loan tenure will result in greater savings in interest pay out, opting for the EMI reduction option will lead to higher disposable income. Hence, the decision to choose between the two primarily depends on what you prioritise – reducing your interest cost or increasing your disposable income.
Never factor in your emergency fund for prepayments
The main objective of maintaining an emergency fund is to deal with financial exigencies or to meet unavoidable expenses during periods of loss of income arising due to job loss, illness or disability. Ideally, the size of an emergency fund should be large enough to meet unavoidable expenses such as children’s tuition fee, existing EMIs, insurance premiums, rents, etc. for at least six months.
Utilising your emergency fund for making home loan prepayment can force you to avail loans at much higher interest rates or redeem other investments at sub-optimal prices to deal with financial exigencies.
Also read: Have too many loans? Here’s the order in which you must prepay your debts
Avoid using investments meant for crucial financial goals
In pursuit of saving the overall interest cost, many home loan borrowers end up redeeming their existing investments. However, doing so can adversely impact their liquidity and long-term financial health. They may also be forced to avail costlier loans to achieve their crucial financial goals.
Identify your crucial financial goals such as children’s education or retirement corpuses and use online financial calculators to identify the quantum of investment required for achieving your goals. Do not touch your existing investments set aside for these financial goals for making prepayments.
Compare savings of home loan balance transfers
HLBT (home loan balance transfer) means transferring your existing home loan to another lender at lower interest rates and/or at better terms and conditions. It is especially helpful for those who availed home loans earlier at higher interest rates and are now eligible for home loans at much lower interest rates. The lower interest rate availed on exercising HLBT will reduce the interest payout without impacting liquidity and existing investments.
For example, assume that you have an outstanding home loan of Rs 20 lakh at an interest rate of 9 percent p.a., with residual tenure of 20 years. Now, if you make a lump-sum prepayment of Rs 3 lakh and opt for the tenure reduction option, your residual tenure will come down to 13 years 9 months, thus giving an interest saving of around Rs 13.49 lakh. If you opt for the same residual tenure, then your EMI will fall from Rs 17,995 to Rs 15,295 resulting in an interest savings of Rs 6.48 lakh. However, if you transfer this loan to another lender at 7.5 percent p.a. for the same residual tenure, your EMI will come down to Rs 16,112 leading to an interest savings of about Rs 4.51 lakh, without impacting your liquidity or existing investments. Additionally, the monthly savings of Rs 1,883 in the EMI can then be used towards investing for building your various financial corpus.
Existing home loan borrowers should first explore the scope of transferring their loans to other lenders at much lower interest rates before opting for prepayments. Those opting for the HLBT can consider home loan overdraft option, a home loan variant, if offered by the new lender. In this option, an overdraft account in the form of savings or current account is opened and linked with the home loan account. The borrowers can deposit their surplus funds in the overdraft account and later withdraw from it, in case of fund shortages or requirements. The balance of this overdraft account is deducted from the outstanding loan amount while calculating the interest component. Thus, this home loan variant offers the twin benefits of prepayment and liquidity to their borrowers.
Also read: Switch to repo-linked home loans in COVID times, save on EMIs
Consider returns generated from existing investments
While home loans have one of the lowest lending rates among all retail loan categories, their interest rates are still higher than the returns generated by most fixed income instruments. Thus, those having surpluses parked in fixed income products like fixed deposits, short-term debt funds, etc. not tied to any crucial financial goals can use them to prepay their home loans. However, this relationship will change in case of equity investments. The long-term returns generated by equity investments usually beat the interest rates of home loans by a wide margin. Let’s consider the example mentioned above. If you invest that Rs 3 lakh used for making pre-payment in equity mutual funds for 14 years, and assuming an annualised return of around 12 percent, it should create a corpus of around Rs 14.5 lakh, generating a gain of Rs 11.6 lakh approximately. At the end of 20 years, the corpus may grow to around Rs 29 lakh, deriving a capital gain of Rs 26 lakh approximately.
Existing home loan borrowers looking forward to reduced EMIs and higher disposable incomes should opt for the EMI reduction option while making pre-payments. Those looking for higher savings in interest cost should opt for the tenure reduction option. Existing home loan borrowers having scope for significant savings in interest cost by transferring their home loan to another lender at much lower interest rates, should first exercise the HLBT option.(The writer is CEO and Co-founder, Paisabazaar.com)