Big-ticket size of home loans and their long repayment terms often lead to the total interest cost of home loans exceeding their principal component. Most home loan borrowers try to deal with this scenario by making partial and/or full prepayments. With steep increases in home loan interest rates during the past few months, existing borrowers with surpluses might also consider prepaying their home loans to deal with rising interest costs.
Here are some of the points that borrowers should keep in mind while prepaying their home loans:
Decision to reduce EMI or tenure
Home loan borrowers have two options in hand while prepaying their loans — they can either opt for EMI reduction or tenure reduction option. While the EMI reduction option would result in higher disposable income for the borrower, opting for the tenure reduction option would result in higher savings in overall interest cost.
Choosing between the two options should primarily depend on what the borrower wants to prioritise: reducing the EMI burden to deal with rising interest rates or reducing the overall interest for the loan.
Compare savings from home loan balance transfers
Home loan balance transfer (HLBT) facility allows existing borrowers to transfer their home loans to other lenders at lower interest rates and/or at better terms & conditions. This facility is especially beneficial for existing borrowers who can avail home loans at much lower interest rates due to the improvement in their credit profiles since availing the original home loan. The lower interest rate available on exercising this facility would reduce the overall interest cost without impacting the liquidity and exitsting investments of the borrower. Hence, existing borrowers should first explore the scope of savings by switching their home loans to other lenders with substantially lower interest rates.
Home loan borrowers can also consider home loan overdraft option while opting for HLBT, if offered by a new lender, wherein an overdraft account in the form of a current or savings account is opened and linked with the home loan account. The borrowers can deposit their excess funds in this account and can withdraw from it as per their financial requirements. The balance of this overdraft account is deducted from the total outstanding loan amount while calculating the interest component. This home loan variant offers dual benefits of prepayment and readily available liquidity to home loan borrowers.
Never use your emergency fund for loan prepayment
The primary objective of maintaining an emergency fund is to tackle financial shortages and/or meet unavoidable expenses like existing EMIs, rent, insurance premiums, children’s tuition fee, etc. due to income loss. Ideally, the size of an adequate emergency fund should be large enough to meet all expenses for at least six months.
Using emergency fund for making prepayments can force borrowers to avail loans at higher interest rates or redeem other investments at suboptimal prices for dealing with financial shortages or for meeting unforeseen expenses during periods of unemployment.
Avoid redeeming investments meant for crucial financial goals
Most home loan borrowers often redeem their existing investments earmarked for major financial goals to make prepayments. However, doing so can not only adversely impact their long-term financial health and liquidity, but it may also force them to borrow costlier loans to achieve their crucial financial goals.
Factor in the returns generated from existing investments
Even though home loans have one of the lowest lending rates among all retail loan products, their interest rates can still be higher than the returns generated by most fixed-income products. Hence, borrowers having surpluses parked in fixed income instruments like short-term debt funds, fixed deposits, etc, which are not earmarked for any major financial goal, can utilise these for prepaying home loans.
However, borrowers should note that this relationship will change in the case of equity investments. As the long-term returns generated by equity investments usually outperform the home loan interest rates by a wide margin, borrowers should avoid disrupting their equity investments and continue to invest in them for long-term wealth creation.
A final wordExisting home loan borrowers looking for prepayment of their home loans should consider the EMI reduction option if they prefer higher disposable incomes and reduced EMIs. Those looking for higher savings in overall home loan interest cost should opt for the tenure reduction option. Borrowers having the scope for significant savings in interest costs through HLBT should first exercise the home loan balance transfer option.