How Small Prepayments Can Save You a Number of EMIs?

If you want to repay your home loan quickly, the only way out is to make some prepayments on the home loan. Many use their annual bonuses to make big prepayments on their home loans. Not surprising that average home loan tenure in India is about 7-8 years. What if you can’t manage very big sums for prepayment on a regular basis? The good part is that you don’t have to make big prepayments to close your loan quickly. Even small and regular payments can a big difference. This is best understood with the help of an example.

calculatorYou take a home loan of Rs 50 lacs for a tenure of 20 years. Interest rate is 9% p.a. EMI shall be Rs 44,986.

Let’s consider a few scenarios.

Scenario #1 You pay 10% more every month. i.e., you pay 110% of EMI every month.

You pay Rs 49,484 every month (Rs 44,986 + Rs 4,498)

In such a case the loan gets repaid in 190 months. By paying 19 extra EMI (10% of EMI X 190 months), you have been able to save 50 EMIs. The reason I picked up a 10% higher EMI is that many borrowers may be able to muster up this excess payment.

Scenario #2 You pay 20% more every month. i.e., you pay 120% of EMI every month.

The loan gets repaid in 159 months. By paying 32 extra EMIs (20% of EMIs X 159 months), you save 81 EMIs.

Scenario #3 You pay an extra EMI every year (at the end of the year).

This does not sound too difficult either. The loan gets repaid in 199 months. By paying 16 extra EMIs, you have been able to save 41 EMIs.

Scenario #4 You pay 2 extra EMI every year (at the end of the year).

The loan gets repaid in 170 months.

Do note, in all the cases discussed above, the cost of the loan remains the same. Only the absolute interest paid goes down.

Why Does the Loan Get Repaid Faster?

original amortization schedule
Original Amortization Schedule (No Prepayments)

Under reducing balance loans, a portion of your EMI goes towards interest payment and the remaining goes towards principal repayment. I have discussed the mathematics behind reducing balance loan EMI in detail in this post. When you make a prepayment, the principal outstanding goes down. This reduces the interest portion of next month’s EMI (I assume you have kept the EMI constant). That, in turn, increases the principal repayment during the month. i.e., more principal gets repaid as compared to the original amortization schedule. The same story repeats for the subsequent months.

The end result: This has a cascading effect and the loan gets depleted much faster. Therefore, prepayment helps you save way more than the prepayment amount (You also save on the interest because of the prepayment).

Amortization Schedule with Prepayments (110% of EMI every month)

Do note my calculations assume that there is no prepayment penalty, which is the case with floating rate loans. If you have a fixed rate loan, then pre-payment penalty may ruin your plans of prepayment. Personal loans are typically fixed rate loans. Prepayment penalty in personal loans can be very stiff to discourage prepayment. If you plan a prepayment in such loans, you have to do a bit more rigorous maths to see if it makes sense.

Even with floating rate loans, there may be some restrictions on how many times you can prepay during the year. So, these monthly excess payments may not really be allowed. Quarterly or annual prepayments will still be allowed though.

Home Saver Loans Can Provide You Better Flexibility with Prepayments

The nomenclature may vary. I am referring to home loan products such as SBI Max Gain. For more on SBI Max Gain and how such loans work, refer to this post.

In short, with such loans, there are two accounts, a Loan Account and the Excess Account (let’s call it that). You can put money or take out money from the excess account whenever you want. Your loan account represents your loan outstanding. However, the interest portion of the EMI is calculated on difference between the Principal Outstanding and the balance in the Excess Account. Clearly, if there is any money in the Excess Account, the interest portion of the EMI for that month will be lower. In a regular home loan, if interest is lower than as per original amortization schedule (due to prepayment), more principal gets repaid (than as per the original amortization schedule). Something we also saw in the example discussed earlier. However, in case of home saver loans, that is not the case. The principal goes down only as per the original amortization schedule.

EMI is the same. Principal repaid is same. The interest portion is lower. What happens to the extra amount? It gets added to the Excess Account. Interest saved becomes interest earned.

Since you can put or withdraw money from the Excess Account whenever you want, many borrowers use such loans to keep their short term funds. If your bank offers regular home loan or the home saver home loan at the same rate, then it may be a good idea to go for a Home Saver options.

You get even greater flexibility with prepayments with such home saver loans. You don’t have to explicitly make a request to the bank every time you want to prepay. You can simply put any additional money you have in the Excess Account. You reduce interest outgo (and serve the exact purpose prepayment would have but in a different way) and maintain liquidity with your money at the same time. And you can always request the bank to set off the amount in the Excess account against Principal outstanding.

Continuing with case 1 discussed earlier, if you had paid 110% of EMI every month, at the end of 190th month, the balance in the Excess account will exceed the Principal outstanding. At that time, you can simply use the balance in the Excess account to square off the loan. If you check, even in regular home loan, you would have finished home loan in 190 months with similar repayment. However, with home saver loan, you retain liquidity with the money with Excess Account.

By the way, since you earn interest only by way of interest saved, it is important that you do not let the balance in the Excess Account exceed the Principal Outstanding. In such a case, since extra money in the Excess Account (above principal outstanding) does not help save any interest, you do not earn any interest on the additional amount.

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