Prepayment of home loan or continue the EMI is a question everyone faces after buying a home on loan. Is prepayment of home loan a good or a bad option? Whether to prepay in early years or later stage of loan?
Rajiv is expecting an incentive of Rs. 5 Lakh in May this year. He started thinking on how to utilise this amount effectively for the benefit of his family. He is thinking of prepayment of Home Loan. Since he is enjoying the tax benefits for the Home Loan, will it be good for him to close the loan? Can he invest this elsewhere and generate better returns instead of prepayment of Principal in the Home Loan.
Is Prepayment of Principal a good option in the Home Loan?
Not always. You must decide based on many other parameters. If you are paying an interest rate of 10% on your Home Loan and if you are availing Income Tax deduction for this interest, your actual cost of loan will be 7% only, if you are in the 30% tax bracket. But, if you are in the 20% tax slab, your cost of loan will be 8%, and if you are in the 10% tax slab, your cost of loan will be 9%.
Will you prepay the Home Loan Principal?
If your cost of the loan is 7%, will it make sense to prepay the Principal? If you can invest the amount elsewhere and if it can generate return in excess of 7%, you will stand to gain by not prepaying the Home Loan. But, if you cannot invest and get such returns, it is better to prepay the Principal. For those who can follow strict investment discipline, it will be better for them to continue the EMI and invest the amount for better returns.
Charges on Prepayment of Home Loan
RBI has asked banks to stop levying foreclosure charges and prepayment penalties on floating rate home loans.
Prepayment is better in the early years of the loan
In the early years of the loan, your EMI will be predominated with Interest on Loan rather than the Principal. Let us take an example:
Loan Amount: 30 Lakh, Loan Term: 20 years, Rate of Interest: 10%, EMI: Rs. 28,951.
In the first year, you will be paying an amount of Rs. 3,47,412 by way of 12 EMIs. Out of this, only Rs. 49,642 is adjusted towards repayment of Principal, because an amount of Rs. 2,97,770 is adjusted towards Interest by the lender. If it is a self-occupied house, you are eligible for tax deduction on only Rs. 2 Lakh in a year. In such cases, it is better to prepay the Principal.
Suppose you are repaying Rs. 5 Lakh Principal after paying 12 EMIs, after this, your outstanding Principal will be Rs. 24,50,358. In this case, your number of future EMIs will reduce from 228 to 147. You can close the loan around 7 years earlier than proposed. This is a huge benefit for you. In this case, your Interest payment in the next year will be around Rs. 2.4 Lakh and you can still get the full amount of deduction towards Interest paid. Here, you will be saving a huge interest outgo. But, if you want to reduce EMI and retain the original term of the loan, then the revised EMI will be Rs. 24,049, a reduction of Rs. 4,902 from the original EMI.
What about Prepayment at later stages of the Loan?
In the example given above, suppose the party paid the EMI for 15 years and only 5 more years are left. Let us see the effect of prepayment of Rs. 5 Lakh. After 15 years of EMI, the outstanding Principal will be Rs. 13,62,573. If you prepay Rs. 5 Lakh at this stage, the outstanding loan will be Rs. 8,62,573. This will help you in closing the loan in the next 34 months instead of 60 months, a savings of 26 months. Please compare this with the reduction of 7 years in the term of loan, if you prepay during the early part of the loan.
But the house will be yours, if you close the loan early
Yes, you will have the satisfaction of having the home debt-free, if you prepay the Home Loan and transfer the home in your name as per the records of the lender.
What is your view? Are you in favour of prepayment of home loan?