Home Loan EMI is perhaps the biggest monthly expense item for a number of people. EMIs typically comprise 35-40% of take home salaries of individuals. With such high EMIs, very little is left to invest for other financial goals. To purchase their dream house and to keep their EMIs affordable, people go for long tenor loans. However, not many people realize that longer the EMI tenor, the more you pay in terms of interest.
In this post, I will discuss through illustrations the impact of loan tenor on the total interest payout. I will also discuss how you can reduce the total interest payout by taking small but significant steps.
With Loans, the Power of Compounding Works in Reverse Direction
When you invest for the long term, the power of compounding works in your favor. Similarly, when you borrow for the long term, the power of compounding works in the reverse direction. The longer the tenor, the more you pay in terms of interest.
Let’s consider an example. We will consider the principal amount of Rs 50 lacs and an interest rate of 10% per annum. Let’s see the amount of interest you pay for different tenors of 10, 15, 20 and 25 years.
|Tenor (months)||EMI||Total Interest Paid||Total Interest as % of Principal|
You can see, as the loan tenor increases, you have to pay more towards interest cost.
Please understand the rate of interest on loan is 10% per annum in all the cases. Higher interest payout does not mean higher effective interest rate. Only the absolute interest payout increases with the increase in loan tenor. This happens because with lower EMI (in loans of longer tenor), most of the EMI goes towards interest payment in the initial years. Since very little principal is repaid, you keep paying interest on a higher principal.
On the other hand, when the loan tenor is smaller (and the EMI is higher), you repay principal amount much faster. For instance, with a loan tenor of 25 years, you will repay only Rs 2.9 lacs of principal amount in the first five years. On the other, with a loan tenor of 10 years, you will repay Rs 18.9 lacs of principal amount in the first five years.
Since interest is calculated on outstanding principal amount, faster principal repayment leads to lower absolute interest payout.
After doing this analysis, it may appear that you must go for a loan with a lower tenor. Yes, that’s right. However, there is an additional aspect that you must consider. For the same principal amount and interest rate, lower the loan tenor, higher the EMI. Affordability of EMI is the key. EMI (and accordingly the loan tenor) should be only as much as your monthly cash flows permit. Your EMI should not be too high or else you will soon find yourself in debt trouble.
I Have Already Taken the Loan. Are There Ways to Reduce My Interest Burden?
Yes, there are. The basic principle is that faster you eat into the principal amount, lesser interest burden you have to bear. How do you do that?
There are two ways:
- Decrease the interest rate of your loan. Lower the interest rate, lower the interest payout. You can do this by refinancing your loan at a lower interest rate.
- Repay the principal amount faster. The faster you repay, the less is the principal amount you have to pay interest on. Pay more than the regular EMI. The extra part will eat into your principal outstanding and reduce your interest burden.
Let’s consider a loan of Rs 50 lacs, tenor 25 years and interest rate of 10% p.a. EMI comes out to Rs 45,435 per month. Total interest cost over the 25 years will come out to Rs 86.3 lacs. Let’s consider following scenarios and see if how you can bring down your total interest cost.
1. Pay One More EMI per Year
You prepay an amount equivalent to 1 EMI per year over and above your regular EMI payments. This EMI can be paid out of your annual bonus or other savings. For instance, for a 25 year loan of Rs 50 lacs at 10%, EMI comes out to Rs 45,435. Under this case, you will make an additional prepayment of Rs 45,435 per year. With this, you will be able to repay your loan in 229 months (19 years and 1 month). The total interest cost will go down to Rs 62.3 lacs.
Editor’s Note: You can use our Home Loan EMI Calculator to determine the savings under various pre-payment and extra payment scenarios.
2. Increase EMI by 5% Every Year
You can also increase your EMI amount every year by a certain percentage. The increase can be in line with increase in your salary. For instance, if your salary increases by 5% per annum, you can make it a point to increase your EMI by 5% per annum. If you do this, you will be able to repay loan in just 155 months (12 years and 11 months). This is almost half the original loan tenor. The total interest cost in this case comes down to Rs 44.99 lacs.
3. You Can Do Both
You can take both aforementioned measures at the same time i.e. increase EMI every year and pay an additional EMI every year. With this, you will be able to repay loan in just 140 months (11 years and 8 months) and the total interest cost goes down to Rs 39.4 lacs.
|Repayment Options||No. of months to repay||Total Interest paid||Interest Savings|
|1 Extra EMI per year (A)||229||6,230,683||2,399,828|
|Increase in EMI by 5% per year (B)||155||4,499,818||4,130,693|
|1 Extra EMI and increase in EMI by 5% per year (A+B)||140||3,940,591||4,689,920|
4. Refinance at a Lower Interest Rate
It happens many times that banks do not pass on the rate cuts to the existing borrowers. It may also happen that another bank might be ready to offer you a loan at a lower interest rate. You can be on a lookout for these offers. A reduction in interest rate from 10% to 9% will reduce your EMI from Rs 45,435 to Rs 41,959.That is a saving of Rs 3,476 per month. Over a 25 year period, it will lead to a lower interest payout by Rs 10.42 lacs. You can explore this option along with other measures discussed above. However, please take into account ancillary charges for switching the loan such as processing fees, legal fees etc. before you make the decision.
Points to Note
Affordability of EMI is the key. It is easy to see the lower tenor will lead to lower absolute interest payout. However, it will also lead to higher EMI or higher cash flow burden. Pick up only as high an EMI that is affordable.
Editor’s Note: With floating rate loans, its important to consider future interest rate increases—and corresponding increase in EMI—into account before picking shorter loan tenure with higher EMI. What is affordable today, could become a burden tomorrow.
Apart from the case where you refinance your loan at a lower interest rate, the interest rate remains the same at 10% p.a. Only the absolute interest cost is changing because you are repaying the loan faster. Banks may impose minor processing charges per prepayment tranche. Though prepayment penalty for floating rate loans is not allowed, you are still advised to look into all the charges before you make the decision to prepay.
Housing loans come with tax benefits. Principal repayment up to Rs 1.5 lacs per financial year is an allowable deduction under Section 80C. Interest payment (for a self occupied house) up to Rs 2 lacs is eligible for deduction under Section 24. Before making decision to expedite pre-payment, do look into this aspect and decide whether it is beneficial for you to prepay the loan.
You can use these tricks not just for home loans but for other loans too such as car loans, personal loans etc. These loans are much more expensive than home loans. Hence, overall interest saving is likely to be much higher. However, typically these loans are fixed rate loans. Hence, you may have to pay pre-payment penalty as per your loan agreement. Hence, overall interest savings may come down.