How soon should you prepay Home Loan?
It is almost everyone’s dream to own a home. Majority of people can not afford to buy a home with the cash on hand with them. So, there is a tool called “Home Loan” make your dream comes true. In a country like India, most middle-class people would have availed a home loan atleast once in a life.
When you buy a new home with the help of a Home Loan and start living in your dream home, you feel happy; naturally! However, within very few years you start thinking of re-paying the Home Loan as soon as possible. It happens because you want to come out of the cycle of paying EMI (Equated Monthly Instalments).
Why it Happens?
It is mainly a psychological state where you feel burden of paying EMIs. This burden of paying EMIs goes up gradually year on year. That is because you keep on adding other EMIs of your online shopping, Car Loan etc. and that makes you un-comfortable. As a result of this burden, you think to prepay Home Loan; but it’s “Easy to say, Hard to Do” as your home loan amount is several times higher than your income.
Now consider a different scenario, let us assume that your income has gone-up substantially during the five years of time frame and you have sufficient funds to prepay the home loan. You have made-up your mind and you are going to do so. But wait! Let’s do a calculation. We assume that the loan amount is ₹25 Lakh, rate of interest is 8.2% per annum and Tenure is 240 Months, i.e. 20 Years.
The simple math
From the above figure it is visualized that the total Interest amount to be paid is more than the principal amount and that’s the key motivation to pre-pay the home loan. However, before going to pre-pay the loan, we should check the Home Loan Amortization Schedule. You can check the same on HDFC Website.
Home Loan Amortization Schedule
At the time of writing this article, I have collected this data publicly available from HDFC Website. Please refer below table that represents year wise payment schedule including contribution to interest payment and principal payment.
Understanding Home Loan Interest Rates
Home loan interest rates are calculated on the reducing balance. Also, the interest rate is variable, and it may increase or decrease as per the Central Bank’s (In India it’s RBI) policies. In our example the Interest Rate is 8.20% at which you avail the loan. For the simplicity to understand our case; I am considering the interest rate @ 8.20% per year for throughout the tenure of 20 Years. However, this rate is charged on the reducing balance and not the whole amount of ₹25,00,000/- for 20 Years.
To simplify it further, let convert this variable interest rate into simple interest rate. So, we are paying an interest amount of ₹25,93,578/- on a principal amount of ₹25,00,000/- in 20 Years. So, the interest component comes to ₹1,29,679 per year. That means the simple interest is 5.189% per year throughout 20 Years on a loan amount of ₹25 Lakh.
Scenario-1 pre-pay after 5 Years
Now, consider that you are pre-paying your home loan after 5 Years. From the above table of amortization schedule, you can see that the balance amount is ₹21,94,221 after 5 Years. You have ₹22 Lakh on hand to re-pay the home loan. So far in 5 years you have already paid ₹12,73,395 (i.e. ₹2,54,679/Year X 5 Years). If you foreclose your loan after 5 years you are paying (₹12,73,395 + ₹21,94,221) a total amount of ₹34,67,616/-
Let convert your interest amount in interest rate. So, you have paid an interest amount of ₹9,67,617 within 5 Years on a loan amount of ₹25 Lakh. In simple words the interest amount is ₹1,93,523/year for 5 Years. That means a simple interest rate paid by you is 7.74% instead of 5.189% per annum
Scenario-2 pre-pay after 10 Years
Similar to Scenario-1, consider that you are pre-paying your home loan after 10 Years. In this scenario you are paying an interest amount of ₹17,80,900 in 10 Years i.e. ₹1,78,900 per year. That means a simple interest rate paid by you is 7.12% instead of 5.189% per annum.
As you can see that in both the scenarios, you are ended up with more than 7% rate of Interest. So, actually you are paying an interest rate of more than 10.8% on reducing balance if calculate it based on simple interest rate of 7.25%
The simple (magic) formula
I would suggest that, if you have sufficient funds, then invest it somewhere else and keep paying Home Loan EMIs. In our example if we consider that we have ₹22 Lakh on hand after 5 years of availing the loan, then you can put this money in Fixed Deposits of any standard bank. As on writing this, I have checked the SBI FD rates, and it is 6.75% p.a. for more than 1 year to 2 Years duration.
Now, please see the below calculation with Fixed Deposits started after 5 Years. Your total interest earning in 15 Years of F.D. would be much higher than the interest you are paying in 20 Years on home loans. That is because you are paying a simple interest rate of 5.189% while you are earning a simple interest rate of 6.75%
As shown in the above table, if you keep your F.D. for 7 – 8 Years, then you can pay your EMIs from the interest earned on Fixed Deposit. However, in this case you would not get compounding interest. But at the same time, you will be worry free of paying EMIs.
The Tax Part
I have not considered anything on the Tax part. That is because, you have to pay Income Tax on the Interest Earned on F.D. and you get exemption on interest paid on Home Loan. Also, it depends upon person to person in terms of his / her source of income etc.
A case when you have to pre-pay home loan
Normally I do not recommend to pre-pay the home loan. However, in certain cases such as buying a new home, you have to re-pay the existing home loan before you avail the loan for a new home. Also, please note that tax benefits are applicable on one home loan only.
Other reasons to avoid pre-paying home loan
There are some reasons to consider whether to pre-pay or not the existing home loan. These are as under:
- The rate of interest for housing loans is quite lower than other loans such as Vehicle Loan, Personal Loan etc.
- If you have enough money to re-pay the loan; avoid it. The available liquidity would be helpful in any unforeseen circumstances. If you pre-pay the loan; then that much of liquidity will be wiped out of your pocket.
- You can top-up your home loan for other needs. This way also you can get the loan at attractive interest rates and longer tenure.
Credit: All the Home Loan Data referenced in this article have been obtained from the HDFC Website and the Fixed Deposit Rates from the State Bank of India Website. All these data are publicly available as they are published on their respective websites.
0 Comments