As in any interest rate scenario, many people who have home loans are considering whether or not it is recommended to prepayment of home loans to incur lower EMI payments going forward. Let’s have a look at what is a prepayment of loan is all about and how does it work. One should consider various facts about home loans.

What is the prepayment of a home loan?

  • When an individual decides to pay an additional (over and above your regular EMIs) amount of principal of your loan before the time is called prepayment.
  • This reduces the principal outstanding, which in turn reduces your EMIs or your remaining loan tenure.

How does it Work?

  • About 2 to 3% of the outstanding loan amount is typically levied a prepayment charge.
  • However, as per the recent NHB notification, this has been disallowed going forward.
  • Check with your lender as there are still some loans on which prepayment charges apply.
  • Most of the banks allow part prepayment up to a certain limit without levying on you any prepayment charge.
  • If the prepayment is out of your own income and not from borrowed money, you can prepay any amount without incurring any penalty.
  • You can opt to partly prepay your loan regularly, for example
    • Every 3 months, constantly reducing your principal outstanding, bringing down the amount of interest you will owe the bank.
  • Remember, the longest tenure of the loan will charge you more interest. Part prepayments are a good way of saving on interest payments.

Things to keep in mind before prepayment of 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 loans 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 paid 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 apply 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 a low-risk investment instrument.
  • The impact on tax liability is also a very important criterion 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. People even get a home loan at cheap rates.

Benefits of prepayment

  • There are numerous home loan benefits. Usually, you could find out how much you save on the interest based on the amortization chart provided by your bank. Perhaps, the biggest benefit of prepaying loans is saving on the net interest payable.
  • Moreover, you could own the asset bought on loan earlier than planned. Some banks also allow for part-prepayments to say every quarter.
  • This effectively brings down the principal amount and the outstanding loan amount and subsequently the net interest.

For example

Ramesh took a home loan of INR 20 lakh for 20 years as loan tenure and at an interest rate of 12 percent. At the end of 20 years, the net interest would be Rs. 32.85 lakh. Instead, Ramesh decided to pay two additional EMIs every year, which would mean he could close the loan in 13 years.

His bank loan agreement had mentioned that there would be no prepayment penalty unless he paid off more than 25 percent of the principal in a year. The table below shows two scenarios and how opting to pay extra EMIs in a year actually helped Ramesh save on interest.