Should You Prepay Your Home Loan? Few Things To Keep In Mind

By Adhil Shetty | October 3, 2017

Should You Prepay Your Home Loan? Few Things To Keep In Mind

Home Loan plays a key role in possessing your own property. Although, Home Loan helps you in creating an asset, you should spare time afterwards to plan and clear this debt at the earliest. This will enable you to create wealth and also allocate resources for more asset creation.

People tend to keep their Home Loan duration as long as possible so that the EMI amount burden is less. For example, Rs. 50 lakh Home Loan at an interest of 8.5% p.a. for 30 years tenure would require an EMI of Rs. 38,446, whereas if the tenure is 10 years, then EMI would be Rs. 61,993. This example is indicative that EMIs are less if the loan tenure is longer. But a better way to have a smooth loan transaction could be to take the pre-payment route for your Home Loan. You may enter a phase where you would have some surplus money because of rise in income, yearly bonus etc. This surplus amount can be used for pre-payment of Home Loan.

Let us understand all the complexities related to the Home Loan prepayment.

Should You Prepay Your Home Loan?

It is important to understand the reason for Home Loan prepayment. Banks usually do not charge a prepayment penalty on a Home Loan; therefore, borrowers have the option open to clear the outstanding loan earlier by prepaying the loan, and save lots of interest payment.

Prepayment of loan certainly provides big relief in terms of saving the interest outgo. For example, for Rs. 50 lakh loan (as discussed earlier), you have to pay interest of Rs. 24.39 lakh if paid in 10 years, whereas if paid in 30 years the total interest payment would be Rs. 88.4 lakh! So, saving the interest outgo is definitely one of the key reasons to prepay the Home Loan.

Another reason to prepay could be higher interest on a Home Loan in comparison to Return on Investment (ROI) from low-risk or risk-free investments such as PPF or Bank FD. For example, interest on a home loan is around 8.5% p.a., whereas if you use the surplus fund to invest in avenues such as bank FD, PPF, tax-free bond, etc., then the interest that you’ll get would be only 6% to 7.5% (taxes may be applicable to such income). It means if you prepay the loan, then you can save more interest outgo in comparison to what you would earn by investing it in low-risk investment instrument.

Additional reading: Home Loan Handbook: All Questions Answered

Tax And Loan Prepayment Decision

The impact on tax liability is also very important criteria to decide whether you should prepay the Home Loan or not. In around 50% to 60% of the total tenure of the loan, EMI mainly consists of interest, and a smaller portion goes to clear the principal. In the last leg of Home Loan repayment, a major portion of EMI goes to clear the principal and interest part shrinks continuously. You must assess all the scenarios by figuring out whether you save money by prepaying the Home Loan, or you can save more money by investing corpus elsewhere instead of prepaying.

Let us understand this with the help of illustration as mentioned in the table below:

Tax impact- Should you prepay your Home Loan?

SN

Details

 
A Total Interest Payable without prepayment Rs. ABC
B Total Income tax benefit U/s 80 (C) & Sec 24 without prepayment Rs. XYZ
S Interest you may earn on the amount which you do not use to prepay (After tax) Rs. YXZ
C Total interest Payable after prepayment Rs. DEF
D Total Income tax benefit U/s 80 (C) & Sec 24 after prepayment Rs. XXX
Conclusion- I If, (A-B-S) > (C-D) Prepay Loan
Conclusion- II If, (A-B-S) < (C-D) Avoid Loan Prepayment

If the borrower is young and has the ability to take some risk, then investing the corpus in equity related instruments such as Equity oriented Mutual Funds can provide a much higher return in comparison to what one can save by prepaying the loan.

You can use the fund for creating better and bigger contingency corpus. Apart from Home Loan, if you take any other loan from the banks or financial institutions, then the rate of interest would not be less than 9% or 10% p.a. In an emergency, if you apply for a Personal Loan, then it may cost you 12% to 24% p.a. If you do not have sufficient contingency fund, then you can avoid Home Loan prepayment and use the fund for making bigger contingency corpus.

Make your choice whether to prepay or not, after considering all the scenarios and do not forget to consult your financial advisor before you make up your mind.

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About Adhil Shetty

Adhil Shetty is the Founder and serves as the Chief Executive Officer of BankBazaar.com. Adhil has a Master’s degree in International Relations with a specialization in International Finance and Business from Columbia University in the City of New York, and a Bachelor’s degree in Engineering from the College of Engineering Guindy, Anna University. Adhil is an expert in Personal Finance (Car loan/Home loan and personal loan) and he majorly consults on investment and spends rationalization for the Indian loan borrowers. His guidance is number based with real time interest rate calculations and hence useful for consumer’s real time query.

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