Loan Tenure: Keep it Long or Short?

Want to take out a home loan? What should be the loan tenure? 15 years, 20 years, or 25 years. Similarly, what loan tenure would you choose for your personal loan? 18 months, 36 months, or 60 months? OR What is the ideal tenure for a car loan?

As always with personal finance, there is no fixed answer. For these choices, there is a tug-of-war between the EMI affordability and the interest outgo. Let’s take a deeper dive.

A Longer Loan Tenure Means

  1. A lower (and a more affordable) EMI
  2. More interest to be paid

Let’s consider an example.

You take a personal loan of Rs 10 lacs. The interest rate is 12% p.a.

If the loan tenure is 3 years (36 months):

EMI will be Rs 33,214.

Total payment towards loan repayment = Rs 11.95 lacs (Rs 33,214 X 36)

Total interest paid = Rs 11.95 lacs – Rs 10 lacs = Rs 1.95 lacs

If the loan tenure is 5 years (60 months):

EMI will be Rs 22,244

Total payment towards loan repayment = Rs 13.34 lacs (Rs 22,244 X 60)

Total interest paid = Rs 13.34 lacs – Rs 10 lacs = Rs 3.34 lacs

As you can see, the longer tenure results in a lower EMI but a much higher interest payment.

Note that the cost of the loan is still the same in both the cases. i.e., 12% p.a. The difference is only in the absolute interest outgo.

Should You Choose Longer Tenure?

A longer tenure means a greater interest outgo. And who would want to pay more interest? Doesn’t that make longer tenures bad?

While it may seem that way, we must look at the affordability aspects too. What if you cannot afford an EMI of Rs 33,000, but can manage an EMI of 22,000? In that case, a longer tenure is better because you won’t at least struggle to repay the loan.

You Can Always Prepay the Loan and Reduce Tenure

The loan mathematics suggests that if you prepay the loan partially and keep the EMI unchanged, the loan tenure would automatically go down.

Therefore, if you are unsure about your EMI payment ability or how your EMI payment ability would change in the future, you can always go for a longer tenure. Subsequently when you get a bonus or a salary hike, you can keep prepaying the loan and reduce tenure.

For instance, let’s consider a home loan of Rs 50 lacs. Interest rate of 8% p.a. You have option to keep the tenure at 15 years or 20 years.

Tenure of 15 years: EMI of Rs 47,782 (Total payment of Rs. 86 lacs over 15 years. Interest payment of Rs 36 lacs)

Tenure of 20 years: EMI of Rs 41,822 (Total payment of Rs 1 crore over 20 years. Interest payment of Rs 50 lacs)

After 3 years, the principal outstanding in 15-year loan will be Rs 44.14 lacs. In the 20-year loan, the loan outstanding will be Rs 46.56 lacs.

Case 1: Now, if you have Rs 7.92 lacs and can partially prepay the loan (20-year loan), your loan will end in the next 12 years. That’s a total of 15 years (3+12). The total payment will be Rs 83.92 lacs (Rs 41,822X180 months + 7.92 lacs) OR

Case 2: You could prepay the 20-year loan by Rs 2.42 lacs (46.56 lacs – 44.14 lacs) and request the bank to increase EMI to 47,782 (as in the 15-year loan). The total payment will be Rs 86.27 lacs (Rs 41,822X36+ Rs 2.42 lacs + Rs 47,782X144).

So, you can start with a longer tenure and a lower affordable EMI and prepay the loan to keep tenure shorter and absolute interest outgo lower.

In home loans, there is no prepayment penalty for floating rate loans. Hence, this decision is much easier. When unsure, opt for a longer tenure and keep prepaying the loan and reducing loan tenure.

Prepayment Penalty for Fixed Rate Loans

However, with types of loans such as personal loans, we have a problem. Such loans are likely to be fixed rate loans. For the fixed rate loans, the lenders usually introduce friction in prepayments by imposing a prepayment penalty. This penalty can range from 1% to 5% of the prepaid amount. And this is a problem. This is an unnecessary cost. This makes prepayment costly. Due to this lack of flexibility, it is better if you consider the affordability and the prepayment costs and make an informed decision about the loan tenure.

Very Short Tenure Loans Are Still Not a Big Problem

There is not much difference between a 6 month and a 9-month loan.

For instance, a Rs 1 lac loan at 12% p.a. for 6 months will have an EMI of Rs 17,254.84. Total payment of Rs 1.035 lacs.

A Rs 1 lac loan at 12% p.a. for 9 months will have an EMI of Rs 11,674. Total payment of Rs 1.05 lacs.

Difference of only Rs 1,537. At the same time, the EMI is about 30% lower, making it much more affordable.

What Should You Do?

Firstly, while we discuss the loan tenures, you must still exercise discretion while taking loans. Purchases through loans provide instant gratification but the same loans are also a burden on your future cash flows. Therefore, even though loans are not necessarily bad, some discipline will help.

If you must take a loan, affordability is super-important. If the EMI is too high for your cash flows to sustain, you will get into debt trouble very quickly. With a lower EMI, even though you will pay more in absolute costs, there will be a much greater peace of mind.

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