Why It’s Not Always Wise To Prepay Your Home Loan?

Equated Monthly Instalments or EMI’s often form a sizeable component of the monthly expenditure in case of most salaried class homebuyers or those with personal loans. The priority for most of these borrowers is to prepay/partly pay the loan as early as possible.  This would save them from paying extra interest on the loan apart from saving them the hassle of monthly EMI’s.

For example, if you have a home loan of Rs. 25 lakhs for 20 years with an interest rate of 10%, the EMI will be 19,300 for 20 years. This amounts to a total payment of Rs. 46,32,104 out of which Rs. 26,32,104 is the interest component. Any pre-payment or part payment made toward the loan will reduce the principal component wherein the EMI will remain the same but the repayment period will get reduced and thus the overall interest payout on the loan.

In many cases, it is wiser to prepay the loan but there are certain situations where avoiding prepayment may be the more logical choice. Similar to a cost benefit analysis while buying a house, you should also do a detailed comparison of advantages and disadvantages of prepayment of a loan.

When Should you Avoid Prepayment?

In most cases, it is advisable to pay off the loan so that you pay less in terms of interest. But, there are certain cases where you should avoid prepayment and continue servicing the loan. These situations include the following:

1. Prepayment penalty is more than the possible savings: Banks levy prepayment charges of 1%-5% at the time of loan prepayments in order to recoup some of their interest losses as a result of the pre-payment. Additionally, this penalty may also act as a deterrent to those seeking to make pre-payments. Therefore, you must to do a cost benefit analysis in terms of the cost of prepayment and in case the charges are more than the savings made, stick to the EMIs.
2. Better options to utilize the spare cash: The idea to prepay loan looks good if you have spare cash as a result of a recent windfall. In such case you should check for next best use of the funds to prepaying the loan. If you have an investment opportunity that provides better returns offering opportunities, invest in them and avoid prepayment. For instance, if you have 2 lakhs of idle funds, you can either use it to prepay your home loan on which you incur an interest rate of around 10%or you can invest in options such as bonds, mutual funds or stock market. In case the returns on your investment are greater than the interest payout on your home loan, it is better to continue with the loan and use the spare cash to generate higher returns by investing in such options.
3. Home Loan Balance transfer to a lender offering a lower rate: Financial institutions provide facility of transferring the loans to another institution (along with some penalties) in case the rate of latter is less. It is advisable to estimate the overall savings by using an online home loan balance transfer calculator and if the results are encouraging, transfer the loan at the lower rate offered by the new bank to get benefits of the lower rate.
4. Prepayment during the later phase of loan tenure: All the banks charge their interest component in the initial phases of repayment. If you look at the repayment schedule, the principal component is low in the initial phase and increase towards the end of the tenure. It does not make sense to prepay the loan in case it is close to being paid off as most of the interest payment s are already done and the current EMI charged is covering mostly the loan principal. In such cases, it is better to avoid prepayment and invest the money in other more lucrative avenues.

Advantages of prepayment of loans

• The very fact that no further payments to be made as equated monthly instalments to your lender can give you peace of mind.
• Paying early ensures that you need not spend any more on making interest payments to the banks for the full tenure of the loan. The interest savings thus generated is in fact indirectly income earned.
• With no monthly payment requirements towards servicing of the loan, the remaining income can be used to meet other objectives or financial obligations.
• Security in terms of possession of the property. With completion of loan prepayment, risk of losing ownership of the house due to home loan defaults resulting from situations like job loss or health concern also gets mitigated.

Disadvantages of prepayment of loans

• Biggest disadvantage will be the loss of tax deductions advantage. As per law, the principal of up to Rs. 1.5 lakhs and interest up to Rs. 2 lakhs is tax deductible on the home loan.
• In order to prepay the loan, the borrower may end up exhausting all funds or income and may not have any retirement fund or contingency fund in case something unexpected happens.