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Should you prepay your home loan?

Abitha Deepak, Bankbazaar.com | January 29, 2009

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Everyone dreams of owning a home, which actually symbolizes a safe haven of security to retire to after a hard day's work and a place where you can be yourself. This cozy nest is not actually yours just yet, legally speaking if you took a home loan for the property.

Are there times when you feel really impatient about this one nagging factor? That you need to wait several more years to free your home from debt? Also, with floating interest rates in a zig zag mode in the past few years, haven't you thought about closing your loan soon before it becomes a lifetime repayment habit you cannot escape from?

Well, here is a thought for you. Have you considered prepaying your home loan? Here are some pointers in that direction.

First you need to check with your bank at what point in time during the loan tenure you can start prepayments for your loan. Second, you need to find out whether you can make part-prepayments. Then you need to figure out what is the percentage of the outstanding loan amount you will be prepaying as prepayment penalty charge.

Most banks allow you to prepay up to a certain point without any penalty charge, so you need to ensure that your part-prepayments do not exceed this limit to avoid a prepayment penalty.

If you do pay a prepayment charge keep in mind - the prepayment charge should be considerably less compared to the interest saved.

You can consistently pay a part-prepayment, say every quarter, and conserve some of your savings for this purpose every month. This will bring down the principal you owe the bank, thereby reducing the outstanding loan amount and hence the net interest you will end up paying will consistently drop down.

Saving on the net interest is the significant advantage of prepaying the home loan, other than the fact that you will retain the complete ownership of the house earlier than planned. The longer the loan tenure, the more the interest repaid, hence its best to repay your home loan in the shortest loan tenure possible, provided it can be managed comfortably within your income.

Banks will usually cap your maximum EMI at about 50 per cent of your current monthly income. However you can make use of pay increases and bonuses to make part-prepayments on your loan.

Here is an example that illustrates how much interest you can actually save, when you opt to prepay your home loan.

Sharma took a home loan of Rs10 lakh (Rs 1 million) for a loan tenure of 20 years at a 12 per cent interest rate. At the end of his loan tenure, Sharma would have paid a net interest of Rs16.43 lakh (Rs 1.64 million). Instead he chose to use his annual bonus to pay two additional EMIs every year, and thus was able to wrap up his loan by the end of 13 yrs. Since his bank did not charge him a part-prepayment fee unless he paid off more than 25 per cent of the principal in a year, he did not have to pay any prepayment fees.

Your bank will provide you with the amortization table, based on which you can make your calculations on how much interest you will save.

The above table shows the results of the interest calculation based on prepayments made, which has enabled Sharma to close the loan 7 years earlier than planned. As a result he was able to save significantly, as the table above shows that by prepaying, he lowered the interest he paid on his home loan by 40 per cent.

Even if Sharma did have to pay a prepayment fee of four per cent, since the total amount of his prepayments is Rs 264,000, his prepayment fee adds up to only Rs 10,700.

Given that prepaying the home loan saved Sharma over 650,000, we see that the small prepayment fee does not alter the fact that Mr. Sharma made a very good decision by prepaying his loan.

In conclusion, if you can afford to make larger payments towards your home loan, perhaps because of a promotion or because of a bonus, then making prepayments towards your home loan is a very good idea as it will save you a lot of money over the term of the loan.

The author is head of Content & Research at BankBazaar.com

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