Understanding Home Loan Prepayment

When one increases the tenure of their home loan, the amount of money that goes into payment of interest also increases. This interest payment you make to the bank is your burden that one shall strive to reduce it as much as possible. When one is prepaying the home loan it means he is paying extra principal component of home loan. Prepayment does not reduce your EMI but it will allow you to close your home loan much earlier. By paying early you are actually saving the interest payment. Buy prepayment become more effective if one is making prepayment in the early phases of loan tenure. Assume that one is taking a home loan of say Rs 30,00,000 at rate of 10.5% per annum for a period of 20 years. The proportion of ‘principal’ verses ‘interest’ during the tenure of 20 years will look like this.

So from this chart you can easily make out that in the first years of home loan payment, banks draw the interest portion of your home loan more than the principal. In this article we will see how prepayment can make your pay-off your home loan early and will also in turn save interest payment. But before that lets look at some basics.

How EMI’s on Home Loan is calculated.

The formula for EMI calculation is:

E = EMI

P = Principal

r = monthly rate of interest (Interest is 10.5% it means r = 10.5/12/100 =0.00875)

n = time in months

Lets take an example, home loan of say Rs 30,00,000 at rate of 10.5% per annum for a period of 20 years (240 months). The EMI in first year will be:

E = 30,00,000 x 0.00875 x [(1+0.00875)^240 / {(1+0.00875)^240}-1} = Rs 29,951 per month for next 20 years.

Before you decide to prepay your home loan, evaluate the requirement. If you are confused whether to use your extra saving to do investment or for home loan prepayment, then here is the solution. If you are investing in stocks, then probably your long term return will be close to 12% per annum. Compare this return with your home loan interest rate. If home loan interest rate is higher than 12%, it means your should prepay your home loan first. But if the home loan is more than 3% lower than your stock market averaged returns (say 12%) only then you decide to invest over prepayment of home loan. Logic is to pay your costlier debt before making any investment.

Why we are so concerned about home loan prepayment?

Home loan is probably the biggest loan amount a average middle class Indian will ever take in his lifetime. Considering the fact that the loan amount is so big, so often people go for very long payment tenure of 15 to 20 years. So not only the loan amount is big but also the tenure is so long, this makes the interest burden like a mountain. For example, for a home loan of say Rs 30 lakhs, for 20 years at rate of 10.5% per annum, one will pay more than Rs 41 lakhs as interest. So in this case you can see that the interest portion is even bigger than the loan amount itself. So it is a must for all loan takers to evaluate the possibility of reducing the interest burden. Home loan prepayment is one effective way of reducing the interest burden. Lets see how much interest payment we can save in total by making even small additional contributions to our EMI.

Lets take an example, home loan of say Rs 30,00,000 at rate of 10.5% per annum for a period of 20 years (240 months).

 SL EMI (Rs) Extra Payment as prepayment/ month (Rs) Total Interest Paid in 20 years (Rs) Savings (Rs) Years for Loan to be 100% paid 1 29,951 0 41,88,335 0 20 2 29,951 500 39,23,348 2,64,968 19 3 29,951 1000 36,95,405 4,92,929 18.1 4 29,951 1500 34,96,554 6,91,781 17.3 5 29,951 2000 33,21,043 8,67,292 16.5 6 29,951 2500 31,64,653 10,23,681 15.8 7 29,951 3000 30,24,198 11,64,137 15.3

From this table you can see that, just by making extra payment of Rs 500/month you are able to save Rs 2.65 lakhs and by making extra payment of Rs 3,000 you can save as high as Rs 11 lakhs in totality. Please note that by making those extra payment you are paying nothing extra, you are just prepaying your home loan. If one is making extra payment of Rs 500/month then they will prepay the home loan in 19 years instead of 20 years.

How to plan home loan prepayment?

Not many of us will have that surplus cash to make a substantial lump sum payment on account of home loan prepayment. So the better strategy will be to make small monthly payments (in addition to EMI’s). Here we will see that even small increment in monthly EMI’s in tune of Rs 500 per month will also make you a huge long term saving of interest. Not only interest saving, prepayment of home loan will also reduce the tenure of home loan.

Every time we make that extra payment of Rs 500/1000 per month, this amount reduces your principal component of your home loan. So if your principal portion is reducing it means that it will indirectly reduce your interest burden (as show in above table).

Before starting to make your EMI payment towards home loan always keep a note of two things (1) how much total interest you are paying against your principal loan amount & (2) Break-up of principal and interest in each year of your loan payment. As shown in the above chart, interest payment in first few tears are maximum and in later years principal payment is maximum.

So if you are interested to get the dual benefits of prepayment, then extra payment shall be made in first few years instead of later. Because if you are not making payment in initial years you are actually paying back all your interest to bank. If you are making extra payment in later years you will only save the principal portion of your home loan.

Some Easy to remember tips related to home loan prepayment

(1) If you are interest in prepayment of your home loan then start from the first few months. You will save more interest that earlier you start.

(2) If you have loans on your credit card, personal loan and home loan, then you must start with the prepayment of your costlier debt first. Credit Card should be your priority one, then personal loan and in the last home loan.

(3) Make sure that you have declared the interest and principal component of your loan to your income tax manager. This can save you a lot on income tax.

(4) As per present directive of RBI, no bank can charge you prepayment penalty. So do not be fooled by banks if they are asking you to pay fine for prepayment of your home loan.

source: GetMoneyRich