Should you pre-pay your Home Loan?

Higher disposable incomes, a burgeoning ambitious middle class & the rise of nuclear families have fueled the widespread proliferation of home loans in India in the past few years. In spite of this, considerable confusion still abounds about the various permutations and combinations when it comes to making prepayments! The chief dilemmas being:

1. If you have a lump sum available, should you invest it, or use it to prepay your loan instead?
2. If you have a monthly surplus, should you save it through SIP’s (and accumulate a lump sum for making a bullet shot prepayment a few years down the line), or use it to make a monthly pre-payment of your home loan?
3. How do the tax benefits that you receive under Section 24 figure in all this?

Although every loan has its own nuances and complexities and your individual scenario can be best evaluated by a qualified Financial Planner, we’ll try to jot down a few key thumb rules in this article, which could form a base for your future discussions and decision making process.

Assumptions

We’ll be assuming the following for the purpose of this article:

1. Your loan is on a floating rate, at an interest of 10.25% per annum
2. To err on the side of conservatism, we’ll assume that the interest rate stays the same throughout the loan tenure (as modeling complex scenarios based on fluctuating interest rates is beyond the scope of this article)
3. The loan tenure is 240 months, and has been freshly taken out two months ago
4. After making pre-payments, you’ll opt for the same EMI and a shorter tenure (as this invariably leads to more savings than the other option, reducing the EMI and keeping the tenure same)

What’s your loan composed of?

To put things in perspective, let’s begin by examining what your EMI is actually composed of, and how this composition changes over the years.

Two things become clear from the above table – Firstly, the initial 10 years (and particularly the first 5) of your loan period are “interest heavy” while the last 10 years are “principal heavy”. Secondly, the bulk of your interest (60-70%) is actually paid back in the first half of the loan tenure.

Our advice in a nutshell

Based on the above, here’s our advice in a nutshell:

1. A prepayment is most effective when made in the first five to ten years of the loan tenure. Prepayments must ideally be planned in this phase. The earlier, the better.
2. If the choice is between making a monthly prepayment and starting an SIP, we recommend starting an SIP in an equity mutual fund for a tenure of five years (and using the accumulated lump sum to make a prepayment at a later date). Doing this creates an ‘interest arbitrage’ of sorts as the long term returns from equity SIP’s have traditionally been higher than home loan interest rates*.
3. If your loan is already in a mature stage (>10 years) and you have a windfall gain, you’re probably better off continuing with the EMI’s and investing your lump sum in a well-diversified portfolio instead
4. Given that the maximum tax deduction under Section 24 is Rs. 2 Lacs per annum (an interest of Rs. 16,700 per month), you can save a maximum of Rs. 61,800 per annum in taxes (if you’re in the highest tax bracket). In the broader contest, this is an insignificant amount as the interest savings from making a prepayment will likely outweigh this figure by a big margin. In short, don’t let the tax savings play too heavily on your mind while taking the decision to prepay!
5. When making a prepayment decision, also consider the ‘non-financial’ gain of owning your property earlier! You can’t put a price tag on being ‘financially free’, but it’s always wonderful to be ‘loan free’ earlier in life so that your mental energies are freed up for other more important things.

Are you paying a home loan EMI? We strongly recommend a more detailed discussion with your Financial Planning Manager to customize your pre-payment plan. Get in touch with us today!