Prepaying a Home Loan-Good Idea or Bad

Introduction

A home loan is an agreement between the borrower and a lender.  The loan needs to be repaid regularly over a while. That amount is called Equated monthly instalments (EMIs). The EMIs, the borrower, pays will first consist of paying off the interest for the loan. After that, the amount will be used for paying off the principal.

Instead of paying what is due in regular intervals, borrowers can prepay the entire loan amount. Let us see how and why they do this.

The term for a home loan can go on for a few decades. The borrower has to keep paying interest throughout the tenure of this loan. That can be quite a considerable sum, and sometimes, the interest paid over so many years might be as much as the loan amount borrowed.

Home loan prepayment

Assume a borrower wants a home loan of ₹20,00,000. At an interest rate of 11% and for 15 years, the borrower would have to pay equated monthly instalments of ₹22,732. The total interest payable for 15 years is ₹20,91,749. The total amount payable is ₹40,91,749.

You can reduce the time taken to pay this money is to have a prepayment plan. If the borrower pays an additional amount as prepayment, the 15 years needed to pay the amount can be reduced. The borrower can either pay the amount as monthly instalments or can pay a lump sum amount.

Assuming no other EMI has been made and the borrower makes a lump-sum prepayment amount of ₹5,00,000. The amount due is reduced by ₹5,00,000. Accordingly, the EMI to be paid each month is also reduced to ₹17,049. That means the borrower can pay off the loan amount sooner than expected. That also results in considerable savings in the amount of interest to be paid. The more the prepayment, the lesser the number of years it takes to pay the loan.

Home loan prepayment rules

Calculation of opportunity cost:

One of the first things that a borrower needs to do before prepaying a home loan is to calculate the opportunity cost. That is the cost that a borrower would incur by not using that money for some other purpose. A borrower might want to prepay a home loan because of a surplus of cash. That surplus money can be used for other means. It could be used for some further investment or to pay some other loan. If the opportunity cost is less than the money saved through interest, then it is better to prepay a home loan.

Credit limit utilisation

Before prepaying a home loan, a borrower also needs to realize how much credit limit has been utilized. Generally, a borrower’s EMIs shouldn’t go beyond 30%-40% of their monthly income. If it does, it will lead to higher credit utilization. The borrower needs to limit this credit utilization.To limit this credit utilization, it makes sense to prepay the loans. This will help in the future, in case the borrower’s financial situation worsens. Also, by limiting the credit utilization, the rest of the money can be used for other savings and investments.

Savings for an emergency fund

Before prepayment, the borrower also needs to ensure that they have a proper emergency fund. Because of the uncertainty in the market, it is considered better to use a surplus of funds towards emergencies, rather than for prepayment of loans. The money leftover can be used for prepayment of loans.

Conclusion:

No matter how big or small a borrower’s loan amount is, it is better to set aside a certain sum to pay off the loans. There are no fixed prepayment rules. Prepayment done in earlier years is better than prepayment done later. But before venturing out to do so, a borrower needs to have adequate emergency funds and savings to look after long-term goals.

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