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A home loan can be the biggest debt in your life. This is because, in addition to the huge principal repayment you make, the long tenure results in a substantial interest outflow. A home loan of Rs. 30 lakhs at 10% interest rate over a period of 20 years will require you to repay a total amount of Rs. 69.5 lakhs, which entails a total interest amount of Rs. 39.5 lakhs, which is even more than your loan amount.
In such a situation, you can increase your EMI amount to reduce the loan tenure, and thus reduce your interest outflow. But doing this may not be realistic for everyone as you will need to manage your monthly cash flows, without causing a strain. The most feasible option in this case is to part-prepay your loan. All banks and housing finance companies were recently directed to do away with pre-payment penalty. So now there is no limit on the amount and number of times you pre-pay the loan in a year. But is it beneficial to prepay your home loan every time you get a windfall or a bulk amount of cash? Or is it better to not pay it in some situations? Let’s explore.
When is it better to repay the loan?
The initial 5-8 years of your loan is when the maximum amount of your EMI goes towards the interest. Hence the best time to part-prepay your home loan is during this time. The amount you part-prepay to your bank fully goes towards reducing your principal amount, which in turn will bring about a reduction in the tenure and interest outflow. You must also consider how stable your income is. If you are in a job which does not guarantee stability of income or if you are running a business which does not guarantee regular cash flows, you should repay your loan whenever you have chunky cash-flows. When you part-prepay, your EMI to Income ratio also falls, which exerts lesser pressure on your monthly cash flows.
You should also consider repaying part of your loan if you think interest rates are likely to harden. This is because as rates in the economy go up, your floating rate home loan also will witness a higher interest rate. This will either result in an increase in the EMI or an increase in the loan tenure. It is advisable to bring down the tenure and pay off the entire loan before your retirement.
The most common and important debate when we talk about prepayment of home loan is whether to use your lumpsum cash to pay the loan or to invest this amount. Remember, when the interest rate on your home loan is higher than the post-tax interest rate you can earn from various investment avenues, it is better to pay the loan. This is especially true if you are above 40 years of age, as the earlier you pay off, the better. However, it should also be kept in mind that interest rate cycles move up and down. Further, returns from equity related instruments can be volatile.
When is it better not to repay the loan?
As discussed above, you must compare the returns from your investment and the interest on your home loan. Usually, when the interest on home loan is considered, an important factor is ignored. This is the tax benefit you get from your home loan. The principal component of your EMI is included under Sec 80C deductions and the deductions for the interest portion falls under Section 24. Hence you must always take this factor and the associated benefits into consideration, when you compare the rates. If the interest rate on your home loan after considering the tax benefits you get is lower than the return you can expect from investing, it is better to invest your surplus amount than repaying your loan. This makes more sense if you are under the age of 35, as you can anyway repay the loan before retirement.
Shifting your home loan from one bank to another:
With pre-payment charges waived and banks becoming more and more competitive in the home loans space, a majority of home loan borrowers shift from one bank to another, if they get better deals on the rates. The interest rate is the most important factor one has to consider while dealing with home loans. So while shifting banks to reduce your interest outflow makes sense, there are a few things to be considered:
1) When you shift banks, the new bank charges you processing fees, which is either a flat amount or a percentage of your outstanding loan. Do not forget to take this into account. However, this amount will be much lower than your total savings over the loan tenure.
2) Some banks allow you to opt for a lower interest rate on payment of a conversion fee. This amount is almost equal to the processing fee you will pay in the new bank. So if the new interest rate you get in your bank after payment of the conversion fee is the same as the new bank’s rate, it is better to stay with your bank.
3) Shifting your loan requires submission of income and property documents along with a full KYC to be done at the new bank. Though this results in a short-term pain, moving to lower interest rates will be beneficial over a long term.
You decision to part-pay the loan or shift it to another bank depends on several factors, including your financial condition and the macro-economic scenario. Remember, your main aim should be to maximise your earnings, either by reducing your interest outflow or by maximising your investment returns.
At the moment, interest rates are on a higher side and it is widely expected that rates should come off in next few quarters. In the last monetary policy review, RBI has given adequate signals that they will consider reducing key bank rates. It is likely that in next 1-2 Quarter rates on Home Loan are likely to come down. When you are restructuring your home loan, it is advisable to go for a floating rate loan, at the moment.
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