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Should I prepay if I am half way through my loan tenure?

A common question that is asked around the coffee machine these days is; should I prepay my home loan? The trigger for this question is quite obvious. Most home loan borrowers in the last 5 years have taken floating rate loans and banks have increased int

Harsh Roongta

14 Aug 2007

A common question asked around coffee machine these days is; should I prepay my home loan? The trigger for this question is quite obvious. Most home loan borrowers in the last 5 years have taken floating rate loans and banks have increased interest rates on these loans three or four times in the last one year itself.

Many home buyers, who thought they were fortunate to have got a floating rate loan at 7 per cent in 2003, are now finding that their sense of \"luck\" was misplaced. Banks are now charging them around 11.50 per cent interest rate. If the loan was for Rs 10 lakh and the original tenure of the loan was 20 years, the increased rates would change the EMI from Rs 7753/- to more than Rs 10,000/- or if one were to keep the EMI amount same, then the tenure would increase by more than 10 years. Typically, banks would let the tenure increase to a maximum of 25 years.

What are the options before the borrower?

As a rule, it is always advisable to prepay any loan, including home loan, if you have spare cash. The only exceptions to this would be:

1. If the borrower has taken a fixed interest loan at a rate lower than the prevailing interest rates, or

2. If the borrower enjoys substantial additional tax benefit in respect of principal under Section 80C. One needs to work out the pros and cons under these exceptions before taking a final decision.

A common misunderstanding that sometimes trips a prepayment decision is the fact that the principal amount outstanding has not fallen substantially, even after making EMI payments for 3 to 4 years. In the earlier example of Rs 10 lakh, if the borrower decides to prepay at the end of fourth year, the outstanding principal is still nearly Rs 9 lakh.

This is because the borrower is paying back a higher proportion of interest in the initial EMIs. The interest component could be anywhere near 80% in the initial months. Interest component comes down and principal component increases as a proportion of the EMI as the loan tenure matures.

This often leads to a common mistake of assuming that it is better not to prepay, say, after half way through the loan tenure, because the interest component is low now. But the fact is that the interest outgo as a percentage (which is what the interest rate is) on outstanding principal is the same whether it is after the 24th month or after the 120th month.

Since interest rate on housing loans is calculated using reducing balance method, the interest rate is always calculated on the remaining outstanding principal. As the remaining outstanding principal will be lower after 120 months compared to after 24 months, the interest amount which needs to be apportioned across the remaining tenure would also be lower, resulting in lower interest amount component. But the interest rate on the remaining principal would be the same at both the time periods.

So, the decision to prepay one's housing loan should not be driven by the stage of your loan tenure, but by the prevailing interest rate and availability of cash with you.