We, Indians, are averse to debt. Therefore, whenever we have surplus funds, we use it to prepay our loans. However, a home loan should not be seen under the same lens as other lending products such as car loan and personal loan. Unlike other loan products, home loan offers a number of benefits, which might make prepayment unprofitable. But since a home loan is a high value and long-term credit solution, its prepayment can help you save substantially on the interest outgo. Now to help you decide whether you should go for home loan prepayment or not, we have listed a few important home loan prepayment considerations.
Important Considerations for Housing Loan Prepayment
Your Financial Requirements
While prepaying your home loan will save the interest outgo, it will also exhaust the liquid funds, which could have been otherwise used to fulfill your immediate financial goals or medical emergency requirements. Therefore, before going for home loan prepayment, ensure that you have enough liquid funds to take care of your immediate financial goals, medical emergencies or everyday expenses during an unpleasant event such as job loss.
Age of the Borrower
Your age is also an important factor to consider before prepaying your home loan. If you are nearing your retirement, it is best to close your home loan as soon as possible. This is because after retirement, you will have little or no income to spare for loan repayment. Moreover, with increasing age, your medical expenses are also likely to increase, making you more likely to default on your loan. To avoid such a situation, it is better to do away with all your existing dues as quickly as possible.
Stage of the Loan
The primary benefits of home loan prepayment is that it helps you save on the interest outgo. Now much you will save on home loan interest depends on the stage of your loan repayment. The interest component in an EMI is the highest during the initial stage of your home loan. Prepaying home loan in the later stage may not give you substantial savings on interest. In such scenarios, investing your surplus funds towards home loan prepayment or foreclosure is impractical unless you want to take another loan and increase your loan eligibility.
Home Loan Tax Benefit
To encourage more people to invest in the real estate sector in India, the government offers various tax benefits on housing loans. Under Section 80C of the Income Tax Act 1961, you can claim tax exemption of up to Rs. 1.5 lakh per financial year on the repayment of principal amount of home loan. Under Section 24(b) of the Income Tax Act, you can also get tax exemption of up to Rs. 2 lakh on the interest paid on home loan taken for self-occupied house; in case of a non self-occupied house, there is no limit. Full prepayment of your home loan will prevent you from enjoying the above tax benefits. Therefore, consider the tax benefits before prepaying your home loan.
Returns from Investment
The surplus funds which you are going to use for home loan prepayment can also be used for making an investment. But should you prepay your home loan or invest to get better returns is not a question that can be answered without weighing profitability of both the options, your current financial situation, risk-taking capacity and other factors.
When should you invest and not prepay:
- During a downturn such as COVID 19, it would be unwise to utilize all your savings and surplus funds to prepay a home loan. Instead, you must maintain liquidity and savings as much as possible. In such scenario, borrowers must allocate their money into different investment opportunities and create wealth for future.
- In the other scenario, you can also use one part of your surplus fund to make part prepayment on your home loan and the remaining amount to make investment as per your investment strategy. This way you can grow your money in diverse ways while reducing your debt burden.
- As mentioned earlier, the government offers significant tax benefits on home loan on both interest and principal repayment. Continuing with home loan will not only get your tax benefits but will also give you an opportunity to earn returns on well-managed equity and mutual fund portfolios, which historically have yielded returns higher than the interest paid on home loans.
When should you prepay and not invest:
- In case you are servicing other loans besides home loans, then reducing some of the debt burden will be a good idea. However, prepay the loan that has the highest rate of interest.
- Also, if you are a risk-averse investor and usually put your money in fixed deposits and other low-return investment instruments, then it is better to use your surplus funds in reducing your debt burden.
- Age of the borrower is also an important consideration. If you are closer to your retirement, it is advisable to do away with all your existing dues as soon as possible.
Reduce Home Loan EMI or Loan Tenure
When partly prepaying a home loan, you have two options to consider. You can either reduce the EMI or loan tenure. Even though the latter option will help you save more on the interest payout, the choice between the two should be made on the basis of your disposable income.
To help you understand this better, let’s assume you availed a home loan of Rs. 50 lakh 5 years ago at 8% p.a. for a period of 25 years and the current outstanding balance is Rs. 46.14 lakh.
Case 1: Reduced Tenure
If you make a lump sum prepayment of Rs. 5 lakh at the end of the fifth year and opt for a tenure reduction, you will save about Rs. 11.81 lakh in interest payment and your tenure will reduce by 5 years and 5 months.
Case 2: Reduced EMI
However, if you continue with the same tenure, then your EMI will reduce from Rs. 38,591 to Rs. 34,409. And you will earn a total interest savings of Rs. 5.04 lakh. Choose EMI reduction option if the increasing interest rate regime threatens to affect your disposable income.
As per the Reserve Bank of India’s (RBI) guidelines, no lending institution can levy prepayment charges on floating rate home loans. However, in case of fixed rate home loans, lenders usually levy a penalty of 2% of the amount being prepaid. Hence, when deciding to prepay your housing loan, take the cost of prepayment into consideration.
Word of Advice
Prepaying your home loan can surely reduce your total interest cost but doing so by redeeming your existing investments or emergency funds can negatively affect your financial health. Instead of using such funds for home loan prepayment, consider utilizing surplus parked in fixed income products such as fixed deposits and bonds. You can also use funds that are not set aside for any financial goals.
Another option that home loan borrowers can consider to reduce their debt burden is home loan balance transfer facility (HLBT). The home loan interest rates in the last year have decreased marginally. If you opt for home loan balance transfer, your outstanding home loan amount will be taken over by another lender at a lower rate of interest. The reduced home loan rate will reduce your interest payout without disturbing your existing investments or affecting your liquid funds. Before transferring funds, make sure to compare the savings derived from part prepayments with those achieved through HLBT to make an informed decision.