labels: investment - general
Is it time to pre-pay your home loan?news
16 February 2006

Yes, interest rates are rising, but don't rush to pre-pay your home loan, says Sanjay Matai.

Happy days, it seems, are gone; from the borrower's perspective at least. The days of falling interest rates seem to have come to an end, at least for the time being. While interest rates fell sharply from around 2001-02 onwards, we have seen them hardening in the last year or so.

But the fall was very sharp and, comparatively, the rise has been reasonably modest; interest rates are still quite affordable. Moreover, there has been an appreciable rise in average income levels in last two years.

Nevertheless, with interest rates rising (some more hikes are expected going forward) some borrowers are contemplating prepaying — if not in full, at least a part — of their outstanding home loan amounts. The funds required for this could come from bonuses, profits in the stock market, maturity or liquidation of some old investments, etc.

Ideally everyone would like to be debt-free. And a 10 to 15-year period of indebtedness clubbed with the uncertainties of job and life is, obviously, makes for an uneasy situation. From a purely psychological perspective, therefore, one may be better off paying one's debts.

But would you gain or lose by doing so? An example should help us look at the financial perspective.

Say a person took a home of loan of Rs10 lakh two years ago at a floating rate of 7.25 per cent, with a tenure of 10 years. Accordingly, the EMI payable was Rs11,750. The borrower has so far paid 24 EMIs out of the total of 120.

The bank has now raised the interest rate to 8 per cent. This means the remaining 96 EMIs would now be at Rs12,072. Alternatively, the borrower could ask the bank to extend the loan period to prevent the EMIs from increasing. To cover the increase in interest the EMIs will increase from 96 to 100. This means that while the rate increase from 7.25 per cent to 8 per cent may appear steep, the actual increase in EMI is merely Rs322 or four additional EMIs. These are not really significant, and one need not worry too much about small interest rate hikes.

Now let us look at the financial implications from another perspective. This exercise would also be useful if you have the money and can repay, to determine whether to continue with the loan or not.

After paying 24 EMIs, the loan now outstanding is Rs8.53 lakh. The total EMIs amount payable is Rs11.7 lakh. This means the interest component works out to Rs3.17 lakh. Let us say the bank would charge 2 per cent as prepayment fee. Should you pre-pay the loan?

If the loan is prepaid, the person would have to pay the bank the loan amount of Rs8.53 lakh and a 2 per cent pre-payment penalty of Rs17,061 — a total of Rs8.7 lakh. But if you decide to continue with the loan, then apart from the loan amount you would have to pay interest of Rs3.17 lakh.

Let us not forget, however, that you would save income tax of Rs95,112 (30 per cent of the interest repayable on Rs3.17 lakh) as the interest on home loans can be deducted from your taxable income. Calculating this, the net interest outgo is only Rs2.22 lakh.

Apart from tax, there would also be an interest earning on the available funds of around Rs8.53 lakh, if that amount were to be invested instead. Even if this amount were invested in a 100 per cent safe instrument like NSC, you would earn a post-tax return of Rs3.82 lakh over eight years. Altogether, therefore, the total cash outflow works out to only Rs6.93 lakh. This is Rs1.77 lakh less than if you were to prepay your loan.

This shows that even when investing in a safe option, the borrower is better off continuing with the loan. If you invest a part of this amount — say 20 to 25 per cent — in equity, you could earn even better returns over the eight years of loan repayment.

Therefore, it is important to analyse the various options available and take an informed decision, instead of being unduly alarmed by small increases in home loan rates.

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Is it time to pre-pay your home loan?