Let’s say that in January 2017 you took a loan of Rs 50 lakh for 20 years at the rate of 9.25 per cent. Your interest outgo for the 12 months of 2017 will be Rs 4.58 lakh. Your projected interest payment over 20 years is Rs 59.90 lakh. However, you receive a bonus of Rs 1 lakh in April and decide to use it to pre-pay your loan. This reduces your interest cost for 2017 to Rs 4.52 lakh — a saving of a meagre Rs 6,000 for the year. However, this has a major impact on your long-term interest cost, which now comes down to Rs 55.05 lakh — a saving of nearly Rs 5 lakh.
When interest rates are low: Another opportune time to consider pre-paying a home loan is when interest rates are trending low, as is the case at present. Lending rates have bottomed out, with the Reserve Bank of India keeping the benchmark rate unchanged over three bi-monthly review cycles. This is a good time to pre-pay your home loan. You can make great progress in your repayment schedule by pre-paying a part of the loan at the current lower interest rate. Doing so will put you in a stronger position vis-a-vis your loan liability at the point when interest rates start rising again. Therefore, even as your equated monthly instalments (EMIs) start rising, pre-payment would lower your long-term interest costs and you’ll clear your debts at a more economical rate.
Suppose, you have a home loan of Rs 50 lakh for 20 years at the rate of 10.50 per cent. Your projected 20-year interest cost is Rs 69.80 lakh. After 36 EMIs, the interest rate falls to nine per cent. Here, you should go for a pre-payment. After 36 EMIs, the loan balance is Rs 47.40 lakh. In those three years, Rs 15.37 lakh was paid as interest. Now, let’s assume that you pre-pay Rs 1 lakh along with the 37th EMI. This sends the total interest paid for year four to 20, hurtling down to Rs 41.90 lakh. Combined with the interest already paid, the total interest paid over 20 years with this pre-payment will be Rs 57.27 lakh. Thus, you will be able to save Rs 12.53 lakh from your original repayment plan.
Lower yield on fixed and recurring deposits: The returns on several fixed-income instruments such as bank fixed deposits and small-saving schemes have fallen. Therefore, it makes sense to divert your additional income towards reducing your loan balance instead of locking it up in investments that give low returns. Always check the current yield rate before arriving at a decision.
Higher disposable income: Assuming that you are left with a high disposable income even after paying your EMIs and meeting all your fixed and variable expenses, and assuming that you are at the start of your loan tenure, you should make a pre-payment. This is because you may not be dependent on your bonus to fulfil your aspirations or the need for discretionary spending.
High EMI: If the size of your loan EMI is troubling you, a pre-payment will help. By using your bonus to make the pre-payment, you can reduce your loan balance. Working with your lender, you can ask for an increase in tenure, which would reduce your EMI to a level where it won’t trouble you.
When should you not pre-pay?
If you are close to the end of the loan tenure: Under income tax laws you can save up to Rs 1.5 lakh on principal payment and Rs 2 lakh on interest payment, if you are repaying a home loan. As you approach the end of the loan tenure, you should evaluate the benefits of these tax savings, since you may lose them if you make a pre-payment.
The RBI has mandated that no penalty should be imposed on pre-payment of floating-rate loans.
However, fixed-rate loans
may continue to attract a penalty. If the interest saving is less than the prepayment fine, it is not advisable to proceed with the pre-payment.
Consider the opportunity cost: Investment in equity funds has the potential to give a return of 11-12 per cent over the long term. Essentially, you will lose out on the two-three percentage points spread if you use your money to pre-pay your home loan. At this juncture you need to decide what your priorities are. Consider returns as well as tax implications. When the returns from an investment option are greater than the savings in home loan interest, it is advisable not to pre-pay the home loan.
Besides pre-paying your home loan, you should also allocate a part of your bonus towards other essential areas of your financial plan. Make sure you have also allocated money towards things like buying adequate insurance, settling credit card dues, and creating an emergency fund. If you are not adequately insured, you must use your bonus to get life and health cover for yourself and your dependants. Alternatively, you can split your bonus between these various needs, and also allow yourself to enjoy the fruits of your labour — by taking a holiday or buying that much-coveted car — but in a planned and calibrated manner.
When pre-payment makes sense
At the start of your loan tenure
Interest rates are trending downward
Interest income from fixed-income instruments is low
EMIs take away a large chunk of your income
When it doesn’t
When you are near the end of your loan tenure
When you are in a fixed-rate loan where a penalty could be levied
If you have the risk appetite to invest in equities
The author is chief executive officer, BankBazaar.com