Home loan prepayment is the best thing that a borrower can do. Most lenders won’t tell you this because they don’t make money until you pay them interest. The smartest way to save money is to close your loans early, preferably through small and regular prepayments.
Prepayment Basics
When you take a loan from a bank or a non-banking financial company (NBFC), it has to be repaid through easy monthly installments (EMIs).
The lender will deduct these EMIs from your bank account on a specific due date and you only need to maintain sufficient balance in your bank account.
EMI has two components, principal and interest. For example, if your EMI is 10,000, a part of it is going to pay interest on your loan and the rest is going towards reducing your principal. This equation varies with time.
Interestingly, the interest component is higher in the initial years of the loan. This component reduces as you move towards the end of your loan tenure.
How does prepayment help?
Whenever you prepay for your loan, it directly goes towards reducing your outstanding principal amount. It is important. Big or small, any amount helps.
This means, your next month’s interest will be calculated only on the remaining principal amount, resulting in two very important consequences. One, the lower interest portion and the other, the higher principal portion – in the next EMI.
This can help you reduce the interest component to a great extent and repay the principal faster for the remaining tenure of the loan.
The end result of your prepayment is that you close your loan much earlier than you initially thought.
So, prepayment is really a good idea but at times, customers may not be aware or may forget to go for the same. Hence, regular micro prepayments that get automatically debited from your bank account are an option worth considering.
Here is an example to understand how prepayment can make a difference.
Let’s say you have taken a loan 20 lakhs at 7.5% interest rate for a tenure of 20 years.
Scenario 1 – Your monthly EMI is due 16,111. you pay in the end 38.7 lakhs at the end of 20 years, which means your interest cost comes to approx. 18.7 lakh on loan of 2 million. Now, when I put it that way, it seems like quite a lot.
Scenario 2 – With regular monthly prepayment of 1,000, you save 2.66 lakhs on your interest cost. This is equivalent to 29 EMIs. It’s like being debt free two years ago just by putting it aside 1,000 every month.
Prepayment, rather, regular prepayment is a superpower for any borrower.
things to note
There are two things to consider before prepaying a home loan.
One, the fee involved in prepayment. If you have taken a floating rate loan, financial institutions cannot charge you a fee for prepayment of the loan. But, if you have opted for a fixed-rate loan, there may be charges for prepayment. So, keep this in mind. Second, the most expensive debt will have to be repaid first.
For example, if you have taken a personal loan or car loan in addition to home loan, prepay the highest interest amount first.
Home loan is a long term commitment. When you decide to take it, choose your lender wisely. Ask them about prepayment and the policies around them. Make sure you can easily do prepayment transactions from your phone like you do everything else in your life.
Manoj Viswanathan is the MD and CEO of Home First Finance Company India.