There’s a certain allure to the idea of prepaying your home loan and stepping into the realm of debt-free living, especially in times of economic/job uncertainty and high interest rates.
If you have surplus money and face a dilemma as to how to use it wisely, here are some guidelines:
Tenure-based approach
Where are you in your loan repayment journey? Whether you’re just starting out or nearing the finish line, it’s often most effective to make additional payments towards your home loan in the early stages.
Take the case of Rakesh who takes a Rs 50 lakh home loan at 9 % p.a for a tenure of 15 years. His mortgage schedule looks like this (see table below). You would notice that while his yearly EMI is constant (Rs 50,713*12), the interest component of the EMI changes in all 15 years.
| Amortization schedule for a Rs 50 lakh loan@ 9 percent p.a. | |||||
| Op. Loan Balance | EMI | Interest payment | Principal | Outstanding Loan Balance | |
| Year 1 | ₹5,000,000 | ₹608,560 | ₹443,293 | ₹165,267 | ₹4,834,733 |
| Year 2 | ₹4,834,733 | ₹608,560 | ₹427,790 | ₹180,770 | ₹4,653,963 |
| Year 3 | ₹4,653,963 | ₹608,560 | ₹410,832 | ₹197,728 | ₹4,456,235 |
| Year 4 | ₹4,456,235 | ₹608,560 | ₹392,284 | ₹216,276 | ₹4,239,959 |
| Year 5 | ₹4,239,959 | ₹608,560 | ₹371,996 | ₹236,564 | ₹4,003,395 |
| Year 6 | ₹4,003,395 | ₹608,560 | ₹349,805 | ₹258,756 | ₹3,744,639 |
| Year 7 | ₹3,744,639 | ₹608,560 | ₹325,532 | ₹283,029 | ₹3,461,611 |
| Year 8 | ₹3,461,611 | ₹608,560 | ₹298,982 | ₹309,579 | ₹3,152,032 |
| Year 9 | ₹3,152,032 | ₹608,560 | ₹269,941 | ₹338,619 | ₹2,813,413 |
| Year 10 | ₹2,813,413 | ₹608,560 | ₹238,176 | ₹370,384 | ₹2,443,029 |
| Year 11 | ₹2,443,029 | ₹608,560 | ₹203,432 | ₹405,129 | ₹2,037,900 |
| Year 12 | ₹2,037,900 | ₹608,560 | ₹165,428 | ₹443,132 | ₹1,594,768 |
| Year 13 | ₹1,594,768 | ₹608,560 | ₹123,859 | ₹484,701 | ₹1,110,067 |
| Year 14 | ₹1,110,067 | ₹608,560 | ₹78,390 | ₹530,170 | ₹579,897 |
| Year 15 | ₹579,897 | ₹608,560 | ₹28,657 | ₹579,903 | ₹0 |
In the first year, Rs 4.5 lakh of interest is paid by Rakesh, which falls to about Rs 2 lakh in the eleventh year of repayment, and so on.
If Rakesh follows the conventional path without making any prepayments, he will end up paying Rs 43.4 lakh in interest, in addition to the principal amount. If he decides to prepay Rs 5 lakh each in the second, third, and fourth years of the loan, he could save a total of Rs 16.38 lakh in interest and reduce his loan tenure by almost three years.
Prepayment in the 5th to the 7th year of the same amount would result in a lower saving of Rs 12.33 lakh in interest payment and a similar reduction in loan tenure. For prepayment made in the 8th to the 10th year, it will be even lower at Rs 8.28 lakh. So, as a strategy, prepay in the initial half of the loan tenure. The earlier the better it is.
Leverage tax benefits
Under Section 24 of the Income Tax Act, the interest paid on a home loan can qualify for a tax deduction of up to Rs 2 lakh annually. Additionally, principal repayment up to Rs 1.5 lakh per annum can avail benefits under Section 80 C.
If you are the sole owner of the property and belong to the highest tax bracket, it makes sense to keep reducing your mortgage until your annual interest payments fall below Rs 2 lakh.
In this case, until the eleventh year, the interest payments are above Rs 2 lakh. However, it will change once you prepay. Moreover, these calculations vary with the modification in the loan amount. So, consult your financial advisor to figure out the optimal prepayment that would give the maximum tax benefits as well as interest savings.
Also, this whole equation changes, if a couple were co-owners of the property and were jointly taking a loan. In this case, interest payments up to Rs 4 lakh can be claimed by them. Interestingly, for them, tax advantages peak out in the third year itself, as per the amortization table, and not in the eleventh year.
Emergency fund first
If you receive a windfall or a bonus and lack an emergency fund, creating one should take precedence over home loan prepayment.
The interest rates on home loans are typically lower than other loans, so if you have other high-interest debts, such as personal loans or credit card balances, it’s better to pay those off first.
Do not compromise on long-term financial goals
Long-term financial goals, like retirement, require consistent and systematic investment. Diverting your retirement savings to prepay your home loan isn’t advisable.
Consider a home loan with a net interest rate of 9%, which effectively costs about 7.1% annually after-tax savings. If your investments yield more than this on a post-tax basis, it’s more beneficial to continue investing.
A retirement portfolio, for instance, usually has an element of equities, given its long-term orientation, which could potentially earn about 9-10% and perhaps even more depending on market conditions, on a post-tax basis.
Additionally, it’s important to ensure that your EMI payments don’t extend beyond your retirement age. If your EMI payments are set to continue into retirement, consider strategies to reduce the loan tenure through prepayment or increased EMIs.
Fine print
Before deciding to prepay, check with your lender about any annual prepayment limits or fees. Typically, there are no prepayment charges for floating-rate home loans, but fixed-rate home loans may have associated fees.
Lastly, don’t hold back from making prepayments until you’ve amassed a substantial sum. Any amount, large or small, can make a significant difference in the final interest payout.
Takeaway
In summary, prepaying your home loan in the initial years can lead to significant interest savings. However, avoid diverting funds set aside for retirement or other financial goals towards prepayment. Take into account your overall financial situation and long-term goals before making a decision.
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