You can check the impact of prepayments on your home loan using our Home Loan EMI Calculator.
You recently landed up a hefty bonus. You have the financial wisdom of not splurging the entire bonus amount on expensive gadgets or a long vacation. You have earmarked a significant amount to prepay existing debt. But, there is a problem. You have a housing loan, a car loan, an education loan and a personal loan. You are not sure which loan to prepay first. Generally, people rush to close/prepay loan which has the highest EMI (equated monthly instalment). Home loans are likely to have the highest EMI. However, home loan provides associated tax benefits and is likely to be the least expensive loan you have. Hence it may not be a wise idea to prepay a home loan on the basis on EMI. So then, what should you focus on?
In this post, we look at various parameters you should look at before deciding which loan to prepay.
Prepay The Most Expensive Loans First
The basic rule is that you must prepay the loan which costs you the most i.e. the loan with the highest interest rate should be closed first. By doing so, you save on interest costs.
Interest rate of a personal loan varies from 14% to 18% per annum. The tenure of the loan is typically capped at 5 years. Interest rates for car loans range between 10-11% p.a. and maximum tenor is 7 years. Interest rate for education loans varies between 10% to 18% p.a. Home loans are the cheapest and are currently available at interest rates ranging from 9.7% to 11.5%. If the interest rate was the only criterion, then personal loans must be paid off first followed by education loans, car loans and housing loans.
However, you cannot simply make the decision on the basis of interest rates on those loans. You must look at effective cost of the loan (due to favourable tax treatment) and any applicable penalty on closure or prepayment of loans.
Loans such as home loans and education loans get a favourable treatment from the Income tax department. In case of home loan, for a self occupied property, principal repayment up to Rs 1.5 lacs qualifies for tax deduction under Section 80C. There is an additional deduction of Rs 2 lacs on interest payment under Section 24. For a property that has been let out (instead of a self occupied property), entire interest payment can be adjusted against rental income. With these tax benefits in place, the effective cost of a home loan (20 years) can drop to as low as 7.2% p.a. (interest rate: 10% p.a.) for a person in the highest tax bracket.
Similarly, in case of an education loan, entire interest paid during the year is deducted while calculating your taxable income under Section 80E of the Income Tax Act. There is no maximum limit on the deduction.
Car loans can offer tax benefits only if you are self-employed. Interest paid on such loans can be adjusted against your taxable income.
Such tax incentives bring down effective cost of the loan. The exact impact will depend on quantum of loan, tenure and interest rate. These tax incentives typically make housing loan the least expensive loan around.
Please note all the tax deductions discussed above have certain conditions attached to them. You are advised to seek services of a tax consultant if you have any questions.
Your loan agreement may have a clause which requires you to pay penalty in case you choose to pre-pay the loan. Floating rate loans do not have any prepayment penalty. However, fixed rate loans (including fixed rate home loans) may have pre-payment penalty clauses. Exact details will be mentioned in your loan agreement. There can be other charges such as processing fees which may be levied on prepayment. Hence, you need to consider this aspect while making your decision. You do not want penalties to offset your savings on interest payment.
We have given various qualitative arguments. Now, let’s try to confirm everything with the help of an example. Let’s assume you have four loans: home, education, car and personal loans. For the sake of simplicity (and to avoid discounting cash flows), we have assumed the tenor of all four to be 5 years. We have taken the same prepayment amount of Rs 5 lacs and try to see interest savings on different kinds of loans. We have considered maximum tax benefits under the housing loan.
|Home Loan||Education Loan||Personal Loan||Car Loan|
|New EMI (B)||53,118||11,377||11,634||10,871|
|Difference in EMI (A-B)||10,624||11,377||11,634||10,871|
|Total EMI savings (C)||6,37,411||6,82,592||6,98,048||6,52,273|
|Tax benefits forgone through prepayment (D)||19,185||54,778||–||–|
|Prepayment Penalty (E)||–||–||5,000||10,000|
|Net cost savings through prepayment (C-D-E)||6,18,227||6,27,815||6,93,048||6,42,273|
|Order of Prepayment||4||3||1||2|
If you had considered only the interest rates for comparison, the order of prepayment (based on Total EMI Savings) would have been personal loan, education loan, car loan and finally home loan. However, after considering tax benefits and prepayment penalty (Net cost savings through repayment) education and car loans have swapped places. Thus, between car loan and education loan, you are better off paying car loan first (despite the fact that car loan carries lower interest rate). Please note, for demonstration purposes, we have taken the absolute value of tax benefits (not discounted to present terms).
Although we have discussed only four kinds of loans there is an additional debt that a lot of us may not even recognize as debt. It is the debt on your credit card. When you make payment for only the minimum amount due on your credit card, you have to pay interest on the remaining amount. The interest rate on such debt can be as high as 3% per month. That translates to 42.3% per annum. And this is just the interest. Late payment fees and service tax can take the effective interest rate much higher. Though any kind of unnecessary debt is bad, credit card debt is evil and is strictly avoidable. So, pay your credit card dues on time. If you are running late on your credit card dues, clear your credit card dues first and then think about prepaying other loans.
Prepay The Loan On A Depreciating Asset
Some experts argue that loans taken on a depreciating asset should be closed first. A few loans such as one taken for a vacation abroad do not create any asset. Car loans or other vehicle loans fall under such category. For instance, if the loan outstanding on your car was Rs 5 lacs and the market value of your car is Rs 4 lacs, then you won’t be able to close the loan even after selling the car. You will have to shell out some amount from your pocket.
For an appreciating asset (or an asset that does not depreciate quickly) such as a house, in case of financial stress, you can at least dispose off the asset to close the loan (as the value of the house is likely to be greater than outstanding loan).
Prepay Or Invest?
Another question that gets asked a lot is whether the excess funds should be used to pre-pay a loan or be invested to earn higher returns. The basic finance rule is that if you can earn a return higher than the cost of your most expensive loan, then you must invest rather than pre-pay the loan. However, the returns on your investment are not guaranteed but you cannot default on your interest and principal payments.
There are investment products (such as fixed deposits) which offer guaranteed returns. But the returns of such products will be less than the effective interest rate on any of your loans (barring a home loan). So, don’t try to be too smart. Prepay the loans with the excess funds.
Interest rate is the most important decision parameter. However, you must not restrict yourself to the interest rate mentioned in the loan agreement. Try to find out the effective interest cost after accounting for tax benefits. Weigh the cost of any pre-payment penalties against potential interest savings. Once you have done that, prepay the loan with highest effective interest cost.
Calculate the impact of prepayments on your home loan using our Home Loan EMI Calculator.