Prepayment of home loan: How it works, benefits, things to be kept in mind

As in any interest rate scenario, many people who have home loan are considering whether or not it is recommended to prepayment of home loan so as to incur lower EMI payments going forward.

Let’s have a look what is prepayment of loan is all about and how does it work:

What is prepayment of home loan?

When an individual decides to pay an additional (over and above your regular EMIs) amount of principal of your loan back, ahead of time that 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 – 3% of the outstanding loan amount is typically levied a prepayment charge, if you prepay above a certain amount, or if you are switching lenders. However, as per recent NHB notification, this has been disallowed going forward. Be sure to check with your lender as there are still some loans on which prepayment charges apply.

At the very least, most banks will allow part prepayment up to a certain limit without levying on you any prepayment charge.

There are still some special cases like SBI; if the prepayment is out of your own income and not 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 longer the tenure of the loan, the more the interest you are paying, so 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 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.
  • 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.

How can prepayment benefit you?

Perhaps, the biggest benefit of prepaying loans is saving on the net interest payable. Usually, you could find out how much you save on the interest based on the amortization chart provided by your bank.

Moreover, you could own the asset bought on loan earlier than planned. Some banks also allow for part-prepayments say every quarter. This could effectively bring down the principal amount and the outstanding loan amount and subsequently the net interest.

Here’s an example

Ramesh took a home loan of Rs 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’ time.

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.

By | 2018-01-09T06:07:42+00:00 November 18th, 2017|Home Loan|0 Comments

About the Author:

Pulkit Jain is the founder of LegalRaasta – India's top portal for registration, trademark, return filing and loans. Pulkit is a veteran CA with over 10+ of experience.

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