Few tips to prepay home loans

Equated monthly instalments (EMIs) for home loan form a big chunk of cash outflow for most homebuyers. The natural tendency is to prepay the loan as soon as possible.
However, the strategies borrowers adopt to make their prepayment vary widely.  Here are some of the ways used to prepay home loans, and how these steps can backfire if not planned comprehensively.

Using savings to pay off the loan, wholly or partially
To pay off the outstanding amount and have all your income at your spending discretion is a very enticing option indeed. In this case, homebuyers prepay the total outstanding with their own savings and close the loan.

While this is a good option, it takes away all cash from your pocket.
This has obvious repercussions in case of emergencies when you may need funds immediately. In such a case, the homebuyer may have to take a personal loan, which charges a much higher rate than a home loan, thus losing even more in interest payments.
The other disadvantage is losing out on a better investment. If you can find an alternative investment option where the rate of return is more than the home loan rate, you should choose the investment over the prepayment.

Refinancing via loan takeover by another bank
This is an oft-used strategy to prepay a home loan. Homebuyers come across offers from banks that are ready to take over the existing outstanding loan at a lower rate, which can bring down the EMI or the loan tenure. This is a better option as it doesn’t impact your savings yet helps reduce the total interest paid over the loan tenure. The problem, however, lies in the processing charges and other fees (if not prepayment penalty) charged by the banks for refinancing as well as closure of home loan.

Sometimes, the interest rate differential is so low that you may end up paying more in one-time charges than you can save in lowered EMI.

Increasing EMI to prepay the loan before the tenure
Homebuyers with salaried jobs find this an easier option. As salaried borrowers progress in their career, promotions and higher pay packages result in higher disposable income. Instead of discretionary spending on new clothes, vehicles, or gadgets, a wiser decision would be to increase the EMI and prepay the loan sooner.

In this case, while you speed up your payment, your ability to raise further loans will diminish. Banks normally fix an EMI to income ratio (or a Fixed Obligations to Income Ratio) for loan disbursement. Obviously, increasing your EMI beyond what this ratio suggests limits the size of the loan you are entitled to in future.

Home saver loan or smart loan
This is a recent offering by banks where they provide a current account associated with the home loan account. The amount on which banks calculate loan interest is the outstanding loan minus the balance in your current account, which lowers the EMI. This allows homebuyers to access this fund in case of emergencies and also take advantage of lower EMI. In essence, you are earning an interest on your current account deposit equal to your home loan rate.

The problem in this case is, if you have a better investment option, you are losing on possible returns. The opportunity cost of not investing in the alternatives that can give you better returns is high. Also, this option may not help if you do not expect to have sufficiently high balance on average in your current account.

Prepaying later during loan tenure
In a home loan EMI, the interest portion is higher in the beginning of the payment schedule. As you keep repaying, the interest component starts reducing while principal component increases. Hence, it makes sense to prepay, if at all, in the beginning of the loan tenure than later in the payment schedule. Prepaying later may not save much in terms of interest payment; instead, it would rob you of crucial liquidity. Some banks may stipulate a minimum number of years of EMI payment before you can prepay. Check with the bank and decide accordingly.

Pitfalls
* Using savings to pay off the loan: It takes away all cash from your pocket, which may pose a problem in case of emergency; Also, you lose out on better investment options
* Refinancing via loan takeover by another bank: It involves processing charges and other fees charged by banks for refinancing as well as closure of home loan
* Increasing EMI to prepay the loan before the tenure: Ability to raise further loans diminishes
* Prepaying later during loan tenure: It makes sense to prepay in the beginning of the loan tenure than later in payment schedule
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About Nitin Aggarwal

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