A day after the Reserve Bank of India hiked the repo rate by 40 basis points to 4.4%, banks started to raise their external benchmark lending rate with a mark-up over the repo rate. As interest rates are expected to rise further this financial year, borrowers who are unable to up their equated monthly instalments (EMI) would see a rise in tenure, leading to higher interest burden.
In such a rising rate scenario, existing borrowers of long-term loans such as home loan and loan against property should go for repayments in addition to regular EMIs to reduce higher interest payouts. However, they should not sacrifice their existing investments for achieving crucial financial goals. Doing so may force them to avail costlier loans later for achieving such goals.
Banks and housing finance companies do not charge any prepayment penalty on floating rate home loans. However, some housing finance companies charge prepayment interest which is simple interest based on principal outstanding and the reference date of prepayment. To save on that, borrowers should make the prepayment in the first week of the month.
Experts suggest borrowers should not wait for years to accumulate a large amount to prepay. Instead, they should start prepaying, say, 5% of the outstanding principal every year. In such a case, on a loan of Rs 50 lakh for 20 years, assuming 7.4% interest, the tenure will reduce from 20 to 12 years and the borrower will save around Rs 21.35 lakh of interest payment. By prepaying 5% of the loan balance every year, around 32% of the loan will be paid through pre-payments and the rest through EMIs, an analysis from Bankbazaar shows.
Adhil Shetty, CEO, BankBazaar.com, says as a home loan is a long-term financial commitment, partial prepayment is a good way to reduce the outstanding loan. “Since most home loans are now at a floating rate of interest, you don’t need to pay the penalty for partial prepayments. If you have excess funds and can repay the loan, it is advisable to prepay or partially prepay as it would reduce the outstanding tenure and overall interest significantly,” he says.
If a borrower can pre-pay Rs 5 lakh a year, then the EMI will reduce drastically to seven years and he can save Rs 31.27 lakh of interest payout. In this case, 60% of the loan will be paid through pre-payments and the rest through EMIs. However, one needs to divert savings towards investments and also look at the opportunity cost of prepaying so fast. Home loan interest rates are much lower than other loans and the borrower gets tax deduction on the principal repayment and interest payouts.
Pre-paying 5% of the loan balance every year may not be optimal if the loan rates spike by a huge margin. In that case, one would be staring at over 100 additional EMIs. “If such a scenario occurs and rates do shoot up dramatically, prepaying fast would help you pay off your dues early,” says Shetty.
Home saver option
Home loan borrowers having restricted liquidity can opt for the home saver option. Under this facility, an overdraft account in the form of savings or current account is opened where the borrower can park his surpluses and withdraw from it as per his financial requirements.
Ratan Chaudhary, head of Home Loans, Paisabazaar.com, says in such a case, the interest cost is calculated after deducting the surpluses parked in the savings/current account from the outstanding home loan amount. “Thus, home loan borrowers would derive the benefit of making pre-payments without sacrificing their liquidity,” he explains.