I have not found too many people who are not in a rush to close their home loans. For some, the obsession is so high that they put everything else, even long-term investments, on the back burner while they focus on closing their home loans. Do you belong to the same group? Nothing wrong in planning to pay off your home loan quickly. But how do you do that?
There are only 2 ways to do this.
- Reduce the rate of interest on your home loan
- Pay more than the scheduled EMIs
There is no third way.
Reducing Interest Rate on Your Home Loan
If the interest rate on your home loan goes down but the EMI remains constant, the home loan will get repaid faster.
Let’s say you take a home loan of Rs 50 lacs at 9% p.a. for 15 years. EMI shall be Rs 50,713.
If the EMI remains constant but the interest rate moves down to 8% p.a., the loan will get repaid in 161 months (down from 180 months).
However, you can’t really do much about your loan interest rate. The interest rates are what they are.
Given the competition in this space, the interest rates from various banks are usually close too.
You just have to ensure that you are not paying a much higher rate than what others are paying. This can happen if you are on an older benchmark and have not bothered to check how interest rates have moved over the years.
Be aware of what your friends, colleagues, and neighbours are paying on their home loans, and you should be OK. If you find that you are paying a much higher rate, it is time to speak with your bank. Quite likely that the bank will reduce your loan interest rate as soon as you raise this topic. If it doesn’t, it is time to change your lender.
Pay More Than the Scheduled EMIs
This is where you have control.
- Pay more than the scheduled EMI every month (or quarter or every year)
- Make partial prepayments as and when your cashflows permit. You can use your annual bonus and any windfall payment (maturity proceeds from an insurance policy) or even sale of an investment. Or can prepay when you have accumulated some money. Or from sale of an asset
(2) seems a more pragmatic approach. The banks may not allow you to prepay more than say 3-4 times a year, making approach (1) complicated. However, if you have an overdraft home loan (such as SBI Maxgain), then this restriction does not exist because the interest is calculated only the net loan amount (Outstanding loan amount – excess money).
The above two options are two sides of the same coin. When you pay more than the EMI, the interest component for the month is still the same. Hence, the entire excess goes towards principal repayment. Hence, outstanding principal goes down faster than scheduled. And this leads to a chain effect. When you reduce principal, the interest for the next month automatically gets reduced. And hence an even bigger part of the next month’s EMI goes towards principal repayment.
No rocket science here. This is how reducing balance loans work.
Let’s look at a few scenarios of how prepayments can help reduce tenure.
- Loan amount = Rs 50 lacs
- Interest rate = 9% p.a.
- Tenure = 20 years
- EMI = Rs 44,986
We assume that the interest rate remains constant during the tenure of the loan.
#1 Increasing EMI by 1% Every Year
In the first year, the EMI is Rs 44,986.
In the second year, you pay 1% more. Rs 45,436 instead of Rs 44,986.
In the third year, you increase by another 1%. The monthly payment increases to Rs 45,891.
Just by making this small change, you reduce the tenure from 240 months to 206 months.
#2 Increasing EMI by 2% Every Year
The tenure goes down from 240 months to 184 months.
#3 Increasing EMI by 5% Every Year
The tenure goes down from 240 months to 145 months.
#4 Increasing EMI by 10% Every Year
The tenure goes down from 240 months to 114 months. Increasing the EMI by a few percentage points should be possible if your career is on the right track. And just look at the kind of impact this has made.
#5 Paying 1 Additional EMI Every Year
You somehow manage to pay an extra EMI at the end of each year. So, at the end of 12 months, you pay an extra installment of Rs 44,986.
With this adjustment, the home loan tenure goes down from 240 months to 199 months.
#6 Paying 2 Additional EMIs Every Year
The home loan will close in 171 months.
You can mix these approaches. You can use any permutation and combination. In fact, you don’t have to take only one of the above approaches. Choose any strategy you are comfortable executing.
The key to closing your home loan sooner is by making prepayments. If your aim is to close your home loan quickly, regular prepayments, no matter how small, can get the tailwind behind you.
It is not always easy to appreciate the huge difference these small prepayments can make. We saw this in the above illustrations. This happens with compounding too. Our brains are just not wired to do such calculations easily. Need spreadsheet software to assess impact of such actions. In fact, loans are compounding in reverse. By making prepayments, you are reducing the impact of compounding against you.
Editor’s Note: Our Home Loan EMI Calculator helps you understand how prepayments accelerate your loan payoff.