Prepayment of home loan can be beneficial to home loan borrowers. But before jumping on it, you should know your “why”? Why do you want to prepay your home loan? It is a myth that all loans are bad. Home loan in particular can be a good form of debt if handled properly.
While on one hand, home loan prepayment can definitely reduce your outstanding loan amount and your interest amount. On the other hand, you may have used the surplus funds to produce better returns or the surplus amount could be utilized for some other purpose.
In this guide, we will discuss about various factors that should be considered for prepayment of home loan and when & how to prepay the loan. We hope that after reading this article, you would be able to decide for yourself, whether to prepay your home loan or not.
Let us look at various factors that you should consider for home loan prepayment.
Factors to be considered for Prepayment of Home Loan
1. Lower Interest Rate
Have you ever noticed that interest rates of a bank can be significantly different for a new and an existing customer? Banks generally offer the lowest interest rates to acquire a new customer and as the interest rates increase in the market they keep increasing the rate in the same proportion. But when the interest rates go down, the same bank will not reduce the rate in the same proportion for its existing customer. Many customers do not realize this as they keep paying the same EMI at higher interest rate. So, if you are paying a higher interest rate than the market, it’s a good reason to consider prepayment of home loan.
Let us understand this with an example. Suppose, your outstanding home loan amount is Rs. 25 lakhs and your current interest rate is 11.5% with a balance loan period of 15 years. Now, if you are getting a rate of 9.9% from another bank, you will be able to make a savings of more than Rs. 4 lakhs even after paying a processing fee of approx. Rs. 12,500. In this case, it is evident from the saving’s calculation that you should definitely prepay your current home loan and get your loan refinanced from another bank @ 9.9%.
2. Alternative Investment vs Prepayment of Home Loan
If you have accumulated some surplus funds either through monthly savings or through annual bonus or some windfall gain, you may consider prepayment of home loan. But at the same time, if you feel that you can make better returns with your surplus funds by investing it in alternative investments such as shares, real estate, mutual funds etc. then you should reconsider your decision. Amount invested in shares and mutual funds has high liquidity. In case you need some money for an emergency, you can immediately take your funds out of your equity investments. However, if making your house debt-free is your priority, then you should prepay your home loan whenever you have surplus money.
3. Future Requirements of Funds
Before taking the decision for prepayment of home loan, you should also consider any fund requirements for near future. For example, you may require funds for your child’s education or marriage, renovation of your house, foreign travel or you may want to keep some emergency fund. As you know, interest rates for personal loans are much higher than home loan, it would be prudent for you to utilize your surplus fund for personal requirements rather than utilize that amount for prepayment of home loan.
4. Home Loan Prepayment Charges
As per latest RBI regulations, banks cannot levy any prepayment penalty on home loans on floating interest rate basis. However, if you have taken a home loan on fixed interest rate, your bank may charge you a prepayment penalty of 2-4%. Also, in case you want to refinance your loan through another bank, you will be required to pay processing fee of upto 0.5%. If after considering home loan prepayment charges and processing fee, you are still making good savings, then you should definitely consider prepayment of home loan.
5. Tax Considerations
Under section 24 of IT Act, for a self-occupied property, you are allowed tax deductions of upto Rs. 2 lakhs on home loan interest amount and for a let out property, you can claim deduction on entire interest amount. So, if your house is self-occupied and any part prepayment does not bring down the interest amount below Rs. 2 lakhs, it will not have any impact on your tax liability. However, in case of let out property any amount of prepayment would directly affect your tax liability.
On the contrary, there can be some tax benefits on home loan prepayment as well. Prepayment of principal qualifies as a deduction under section 80C and hence for someone who is not utilizing the total deduction of Rs. 1.5 lakh, this would be useful.
To know more about tax benefits, you can read our detailed article on Tax benefits on home loan.
When to Prepay Home Loan?
1. Retire higher cost debt first
As a first step, you should check if you have any outstanding personal loan, car loan, credit card debt or any other higher cost loan. If yes, then you should first prepay any such loan because home loan is the cheapest form of debt available and should be retired at last. Once, all your other debt is over, only then you should start thinking about prepayment of home loan.
2. Try to prepay your loan in first half of loan period
You may have noticed that in initial years, maximum portion of your EMI goes towards your interest repayment while maximum principal repayment happens towards the end of the loan tenure. So, it is more beneficial to prepay your home loan in initial years. Therefore, ideally you should try to prepay your loan within first half of your loan period.
3. Pay whenever you have surplus
Sometimes it becomes difficult to plan your prepayment as you may get attracted to another investment option in between. So, whenever you have some spare money in your bank for which you have not planned anything, you should utilize that amount towards prepayment of home loan. In a saving’s account, you get an interest rate of 4-5% and that too is taxable. You should rather reduce your much higher home loan interest.
How to make Home Loan Prepayment?
Prepayment of Home Loan with Increase in Income
1. Increase in Salary
When your home loan is approved, your bank will generally fix your EMI at maximum 40-50% of your monthly take home salary. Now, it is quite natural that your salary will increase over time and you will be in a much better financial position with more spare money. Generally, people have a tendency to spend the surplus money as it gives them immediate gratification. To avoid splurging that extra money and to maintain financial discipline, you can keep paying 50% of your salary as EMI. For example, let’s assume that your current monthly salary is Rs. 50,000 and your EMI is Rs. 25,000. After 3-4 years, say your salary becomes Rs. 1 lakh per month, then you should spare Rs.50,000 towards your home loan EMI. If you maintain the financial discipline of paying 50% of your monthly salary towards home loan EMI irrespective of your salary levels, you can easily pay off your 20 year loan in 7-8 years.
2. Annual Bonus or Windfall Gains
Let us make another assumption that you received a bonus of Rs. 5 lakhs for your outstanding performance this year and your equity investments also did well as you made a profit of Rs. 4 lakhs. Now, you may be tempted to buy a brand new car or go on a foreign vacation. There is no harm in treating yourself, but please remember you are paying interest on your home loan. Instead of splurging all your bonus money and profit from stocks on luxury items, prepayment of home loan should be your first priority. If not all, you should at least utilize part of your annual gains towards prepayment of home loan.
3. Reduced EMI vs Loan Tenure
When you prepay your home loan, you can either reduce your EMI or reduce the loan tenure. If you don’t tell the bank specifically, your loan tenure will get reduced automatically by default, keeping the EMI as same.
We recommend that you choose the default option of reducing the loan tenure as you can pay off your loan faster. However, if you want to spare some money every month for some other investment or requirement, you may opt for reduced EMI.
Who can do Prepayment of Home Loan?
Generally, banks discourage prepayment of home loan because they have to spend again on acquisition of a new customer. One way of such discouragement is that they will ask you to personally visit the bank branch if you want to foreclose your loan. If you are working in same city, it should not be a problem for you to visit the bank and foreclose the home loan. However, these days people shift cities for work. You may have a home loan from a Delhi branch and currently you may be working in Mumbai or New York. But, if you want to foreclose the loan, you can authorize any of your relatives or friends to represent you at the bank.
Final Word
If you prepay your home loan, you save on your interest which is an indirect return on investment. In other words, interest saved is interest earned. Therefore, prepayment of home loan is a great investment option. Unless you have a great alternative investment opportunity at hand which can beat your home loan interest rate, you will be better off prepaying your home loan.
In case you are planning to prepay your home loan using refinancing from another bank, then you must first do your cost benefit analysis.
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