?Time to prepay your home loans?

Buying a home is a dream we all have - it comes with the comfort of a safe space and not having to deal with pesky landlords. With real estate prices touching the sky, it becomes even harder to make this dream a reality without the help of credit. Home loans are a bridge, we use them to get our dream home early in life, but everything comes at a price.

The catch with home loans

With loans come long payment terms and hefty EMI payments, with a sizable interest component. Banks charge high processing fees and are rigid about the terms and conditions of the loan, usually not very forthcoming to requests about tenure and EMI adjustments. The volatility of interest rates also becomes a big issue in the case of floating-rate loans, where the interest payable changes at every reset date.

Why prepay?

With time our ability to pay off the loan faster tends to increase, and it is considered better to pay down debt when we have a little extra money. The amount paid as prepayment is deducted from the principal outstanding. Prepaying cuts down on the loan period and reduces the interest due on the loan amount drastically.

When is the best time to prepay?

Being one of the larger loans one might take in their lifetime, homeowners are faced with the prepayment dilemma. The burning question becomes when is it a “good time” to prepay? The best time to prepay a home loan is during the initial part of the loan when the principal amount due is large.

Prepayment ideally should be started in the first year itself. It reduces the interest burden, cuts the loan tenure, and saves a few EMI payments.

Pick your approach

As seen from the table, for a 50 lakh home loan taken for 25 years at 8% p.a. (assumed constant throughout), the interest component is almost 66 lakhs which is?1.3 times?the principal component. In the first 10 years, one pays off?barely 20%?of the principal. Most of the money paid in the first few years goes towards servicing the loan. The bulk of the loan is paid down after the 15th year.

After prepayment of the loan, there are two options available to the homeowner,

Shorten loan tenure:?the EMI payment value tends to go up for the outstanding loan balance post-prepayment, thus reducing the time taken to pay it down.

Keep the tenure constant:?the EMI value is reduced, and the loan is paid over the same period.

The choice is subjective, but paying off debt early is always better, even if it means paying a higher EMI.

Prepayment vs investment

People often debate whether to prepay or invest. It is considered fiscally responsible to prepay unless one can be confident they will earn a return higher than their loan interest in the long term. Most people tend to prepay as they cannot guarantee the performance of their investments.

Things to keep in mind while prepaying

Prepayment charges:?One can prepay their home loan using the influx of funds after a promotion or a bonus. It is essential to look into the prepayment policy of the loan - usually, banks and NBFCs do not tend to charge prepayment penalties.

The interest rate goes down:?Loan refinancing works better when one pays a higher interest rate than what is prevailing in the market. You take a new loan at a lower rate to pay the existing loan, which acts as a bridge. This is only applicable for new loans that have yet to pay off much of the principal component of the loan. The cost of refinancing a loan might be equivalent to any savings from the same in case of loans that have crossed more than half their tenure.

An example, Ravi can refinance his 45 lakh loan taken at 11% for 30 years at a new rate of 9.5% two years into the loan period for the remaining term.

Conclusion

Prepaying your loan is a good idea, but where the funds used to prepay come from matters a lot. Prepaying should not be done by redeeming existing investments or emergency funds, as it negatively impacts your financial health.