You have a Home Loan for 20 years and you are already five years into it. You get some bonus money that you could use to prepay the Loan. Should you go ahead and prepay? It all depends!
Even though it is good to prepay your Home Loan (it will, of course, reduce your EMIs and help your Credit Score). But this may always not be the right thing to do. We’ll give you scenarios where prepaying is beneficial and also ones where they don’t make any sense at all.
Scenario I – You Have No Other Loans
You have a 20 year Home Loan for Rs. 50 lakh. 5 years have already gone by. You receive a Rs. 2 lakh bonus. Let’s say the interest rate is 10%. Assuming you have no other loans and are enjoying tax benefits on the loan, it makes sense to prepay your Home Loan. This is because you will save Rs. 6,31, 979 of interest.
Not only that, your Home Loan tenure will go down by 1 year and 5 months. Since the tenure will still be over 10 years, the interest portion will continue to dominate your EMIs and you can keep claiming your tax benefits.
Additional Reading: Did You Know About These Tax Benefits on Home Loans?
Scenario II – You Just Started Repaying Your Home Loan
In the initial years of your Home Loan, the interest component makes up close to 90% of your EMI. So, when you prepay you save big on interest payments. However, as you near Loan maturity, your principal repayment will be much bigger than the interest component and prepaying may not be beneficial, especially if you are availing tax benefits.
Here’s an example. Assume you have Rs. 50 lakh Home Loan with 10.5% interest rate and 20 year tenure. Your interest payment will be Rs. 3 lakh a year while principal repayment will be close to Rs. 50,000. If you prepay Rs. 2 lakh of your principal when you are just 2 years into your Loan, you will save Rs. 8.8 lakh of interest. If you do it after repaying your Loan for 15 years, you will save only Rs. 1.2 lakh.
So, prepaying a Home Loan that is near maturity is less beneficial when compared to prepaying a Home Loan that is newly taken.
Scenario I – You Have Other Loans
Prepaying your Home Loan doesn’t make sense if you have other loans with a higher interest pay out. You can save much more if you prepay the loan with a higher interest rate than your Home Loan.
Let’s take an example. You have a Personal Loan of Rs. 10 lakh that you took a year ago. The interest rate on it is 16% and you have 4 more years to repay it. You have, of course, a Home Loan for Rs. 20,00,000 with an interest rate of 9% and the tenure is 15 years. You have already completed 10 years. Now, if you get a Rs. 2 lakh bonus, which one should you prepay?
Here are the calculations. If you prepay your Home Loan, you save Rs. 97,390 of interest you would have paid. Good savings! But wait. If you prepay that Personal Loan (assuming there are no prepayment charges) you will save Rs. 1,45,524. So, it actually makes sense to prepay your Personal Loan, rather than your Home Loan.
Scenario II – You Are Getting Tax Benefits
Home Loans have a host of tax benefits including tax deductions for interest and principal repayment. It doesn’t make sense to prepay your Home Loan if it will reduce the tax benefits you are getting, especially if you are in the highest tax bracket.
Let’s take a scenario. Let’s assume you have taken a Home Loan for Rs. 30 lakh for 15 years and are already 7 years into it. You are in the 30% tax bracket and are availing the tax benefits from the Home Loan. If you repay your Home Loan now, you will lose tax benefit for a year which is worth Rs. 3.5 lakh, while interest saved will be just Rs. 1.9 lakh.
Additional Reading: Don’t Forget About These New Home Loan Tax Benefits
Scenario III – You Have A Home Saver Loan
What if your Home Loan is a Home Saver Loan? A Home Saver Loan is where you hold an account along with the loan and your interest will be calculated after subtracting the account balance from the principal. For instance, if you hold Rs. 2 lakh in your account (linked to the Home Loan) and your principal outstanding is Rs. 22 lakh, your Home Loan interest will be calculated on Rs. 20 lakh (22 minus 2).
In this scenario, if you get a bonus, you can park it in this account to reduce your interest outgo and you also have the option of withdrawing the funds whenever you need. So, prepaying your Home Loan doesn’t make sense.
Scenario IV – You Don’t Have An Emergency Fund
It is totally not advisable to prepay your Home Loan unless you have your emergency fund in place. Financial advisers say that you need to have at least half of your annual salary as your emergency fund. If you don’t have one or the fund is pretty low, use your bonus or other surplus money to shore up your emergency fund before prepaying your loans.
If you are looking at ways to reduce your EMI, consider refinancing your Home Loan. This is relevant now because interest rates are falling. And always do a cost benefit analysis before you prepay your Home Loan. Hope this helps!