When is a good time to prepay or part prepay a home loan? When you think about the above question, the next question that comes to mind is how do you define a “good time”. One of the ways to assess this could be the number of EMIs saved due to your prepayment. Let’s understand this with the help of an example.
Loan Amount is Rs 50 lacs. Loan tenure is 20 years. Interest rate is 9.5% p.a.
Let’s see how prepayment at various times during the loan tenure will affect the number of EMIs. I have considered the prepayment at the end of each year.
|Year||No. of EMIs left at the end of the year||Principal outstanding at the end of year||Prepayment of 5% principal outstanding||Prepayment of 10% principal outstanding|
|New no. of EMIs left (after prepayment)||EMIs saved||New no. of EMIs left (after prepayment)||EMIs saved|
You can see the reduction in the number of EMIs is greater for prepayment during the initial years. At 5% prepayment, the number of EMIs goes down by 28 for prepayment after the first year. The number of EMIs goes down by 16 for prepayment after the 6th year. You can see a similar pattern when 10% of the outstanding amount is paid at the end of the year.
I have considered the repayment of 5% (or 10%) of the outstanding principal for prepayment. Clearly, since the principal outstanding goes down every year, the amount considered for prepayment also goes down every year. For instance, the outstanding loan at the end of the first year, therefore prepayment amount at the end of first year (at 5%) is Rs 49.12 lacs. Therefore, the prepayment amount is Rs 2.45 lacs. At the end of the second year, the loan outstanding is Rs. 48.15 lacs. Therefore, the amount considered for prepayment (at 5%) is Rs 2.4 lacs.
In my opinion, the above is a more just method for comparison than fixed amount prepayment because it eliminates the impact of loan amount from the analysis. However, many of us would prefer to see the impact of a fixed prepayment on the EMI savings. Let’s do that too. I have considered the prepayment of Rs 5 lacs and Rs 10 lacs at the end of each year. Let’s see how the data looks.
|Year||No. of EMIs left at the end of the year||Principal outstanding at the end of year||Prepayment of Rs 5 lacs||Prepayment of Rs 10 lacs|
|New no. of EMIs left (after repayment)||EMIs saved||New no. of EMIs left (after repayment)||EMIs saved|
Why Does This Happen?
For this, you need to understand how the EMI based (reducing balance) loan repayment works. During the initial part of your loan tenure, most of your EMI goes towards interest payment. At the loan repayment progresses and the outstanding principal amount goes down, portion of the EMI that goes towards meeting interest payment goes down while the portion that goes towards principal repayment goes up. Towards the end of your loan tenure, most of your EMI goes towards principal repayment.
When talking about loan repayment, the principal repaid remains constant at Rs 50 lacs (in the examples considered). Any prepayment therefore can only impact/reduce the interest that you pay. Therefore, prepaying the loan has the greatest impact when a big portion of your EMI is going towards interest payment.
Points to Note
- Prepayment does not change the cost of loan. It merely changes the number of EMIs you need to pay to close out the loan. In the examples considered above, the cost of loan remains constant at 9.5% p.a. irrespective of loan prepayments.
- I have kept the interest rate constant during the tenure of the loan, which is an impractical assumption.
- I have not considered the effects of tax benefits on home loan repayment because these will vary for different borrowers and will depend on loan amount and other houses and investments. However, you must still note that the tax benefits for home loan are likely to go down towards the latter part of your loan repayment schedule. This is because the interest portion of the EMI has gone down quite a bit. Therefore, the tax benefit under Section 24 for interest payment will go down towards the end of the loan tenure. The tax benefit under Section 80C for principal repayment is anyways split across many other investment options.
What Should You Do?
Frankly, what we did above is an esoteric discussion. In reality, there is no need to complicate matters. When you have excess cash, it is better to bring down your outstanding home loan down to more comfortable levels. Moreover, when the bank raises the interest rates, it may be a good time to prepay some portion of your loan to keep your EMI constant (or affordable). When you have excess cash and are considering part-prepaying your home loan, our Home Loan EMI Calculator will provide you all the details to help you with decision-making.