Monday, March 25, 2019

Home Loan Prepayment: The Whys and Hows

A few years ago, Misha took a large home loan, at a monthly EMI of almost Rs.37,000 and interest rate of 11.75%. She still has to pay close to Rs.26 lakhs of the principal amount with just a little over 10 years remaining. She is looking for options that can help her diminish the loan burden. As home loans are some of the biggest debts we take on during our financial lives, repaying them often becomes a substantial burden on middle-income earners with a fixed salary. However, there are four ways in which you can reduce your home-loan debt—or at least minimize its effects:

1. Transfer your home-loan to a low interest provider: If Misha transfers her home loan to a lender who levies 10.5% interest instead of 11.75%, her loan tenure comes down drastically. If she maintains the same monthly EMI, the reduced interest brings the tenure down to 113 months from 124. The longer you spend repaying your loan, the more interest you have to pay—therefore, Misha will save approx. Rs.4 lakhs in interest.

2. Increase your EMI and reduce the tenure: This can be availed only if your financial situation changes substantially. For example, you had been saving for your child’s education, but she has already left for college. Or your salary has been hiked by 30% or more. Suppose Misha pays Rs.42,000 a month instead of Rs.36,407 a month— her interest tenure comes down to 96 months from 124, as a result of which she pays Rs.476000 less in interest.

3. Make prepayments: Prepayments are payments made towards your loans in large chunks, and at irregular intervals. Here are the basic ways in which they differ from EMI payments:

  • EMIs are compulsory and regular. You pay them every months, and you pay a fixed amount. While this amount can be changed, there is not much flexibility. Prepayment, on the other hand, depends entirely on the loan taker
  • Prepayments are much larger than EMIs, for example the average home loan EMI can be anywhere between 10,000 and 50,000, while prepayments are numbered in lakhs.
  • The most crucial difference between EMI and prepayment is that a large portion of your EMI goes towards payment of interest, at least towards the beginning of the loan tenure. Prepayments, however, go directly towards your principal, thereby bringing down not only the loan tenure, but also the outstanding loan amount.
If Misha makes prepayment of Rs.2 lakhs for 5 years, alongside her regular EMI of Rs.36,407, her total interest will drop by a staggering Rs.8.5 lakhs and her loan tenure will be almost halved— from 124 months to 73 months. Obviously, out of the three options for reducing the home-loan burden, making prepayments is the most profitable one. But while going down the prepayment route, there are a few things you must note:
  1. You will have to pay interest when you are making a prepayment, i.e. the day you make the payment, your principal will decrease and from that point on you will be paying interest on the reduced principal. But suppose you make a prepayment on the 10 of the month— the interest on the original amount for those 10 days will have to be paid as well.
  2. Some loan providers insist on validating your proof of income before accepting prepayment, as these are usually big ticket payments. Therefore it is advisable you carry bank statements for the account from which you are making the payment, dating back to at least three months.
  3. The longer you take to repay a loan, the more your loan provider will earn. Therefore, accepting prepayment is often not in the best interest of the bank, so there might be measures like prepayment charges and limitations in payment mode. There may be a specific period after loan disbursement during which prepayment is not permitted. Also, the borrower may have to be present personally to make prepayment. Acquaint yourself with these rules and regulations before you take the leap.
  4. Once your principal loan amount decreases, your CIBIL score (which reflects your credit worthiness) will improve. Follow up on your credit score within a few months of making the prepayment, to ensure that the reduction in outstanding balance is reflected.
  5. Make sure to preserve the acknowledgement of payment. This document contains important details such as outstanding principal, home loan tenure, and change in EMI (if any).
The catch is, prepayment is possible only in case of a sudden financial windfall, such as yearly bonus or inheritance or gift. Then you would have the dilemma of whether to invest it and increase savings, or whether to prepay your loan and reduce your debt. Our advice is, if the rate of interest from investment is less that the interest you pay on your loan, it is better to make a prepayment. For example, investing in a provident fund would fetch Misha interest at 8.8 currently, while her loan interest rate is 11.75. Therefore, making a prepayment makes better financial sense.



This is a guest post by Team Paisabazaar

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