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Pay higher EMI or increase home loan tenure?

The home loan taker's dilemma: Pay higher EMI or increase tenure?

Harsh Roongta

23 Apr 2008

With interest rates rising on your home loans, should you pay a higher EMI or increase the tenure of your loan?

Mr. Ratan Shetty, who works with an IT company, took a home loan of Rs. 10.5 lakh at an interest rate of 7 per cent for tenure of 20 years in May 2005. At that time, he was paying an EMI of Rs. 7443. In just two years, the interest on his home loan rose to 11.25 per cent, and his EMI increased to Rs. 10,453, a rise of more than Rs.3000 per month.

When interest rates rise, home loan takers like Mr. Ratan have few options.

Say if his EMI currently is Rs 10,453 (as explained above), he can opt to pay more. But, this option is available only if his income permits the extra outflow. So all out there, who have had a pay hike; this is just the right option.

Another option is increasing the home loan tenure. If his home loan tenure is 20 years according to the loan agreement, he can make arrangements with the bank to increase his loan tenure to 25 years. Banks will be willing to offer this option based on the age of retirement. This option is offered especially if the home loan installments have increased and Mr Ratan's income is just the same!

There is another option with which he will strike gold, but er...Mr Ratan will need surplus cash. If he gets extra funds, he can choose to make a partial prepayment towards the home loan. This amount will be adjusted against the outstanding principal component of the home loan. This is the best way to retain the original EMI and tenure of the home loan.

Which option is the best?

That depends on your age, your overall financial situation and the future course of home loan interest rates. Let's look at the advantages and disadvantages of each choice. Pay a higher EMI.

If you have taken Rs. 10 lakh loan for a 10-year term, a half a percentage increase in interest rates will increase your EMI by around Rs.290. If you expect interest rates to rise in the future, increasing your EMI may be the best option because you have the advantage of not prolonging your loan period at higher rates. In addition, you may also be able to get tax breaks on your increased interest outgo.

The disadvantage is the pressure that the higher EMI puts on your monthly budget. You may have to sacrifice some aspect of your lifestyle or reduce your financial investments. If you are financially over-stretched now it may be better to keep the same EMI and lengthen the tenure.

Increasing the tenure of the loan

If interest rates fall in the future then you will benefit from this strategy; the opposite holds if interest rates rise. In a rising interest rate regime, increasing the tenure of the loan will increase the cost of your home.

One problem with extending your loan is that banks generally don't extend tenure beyond retirement age (generally considered to be 60 for salaried individuals and 65 for self-employed). Therefore this option may not be available if you are close to retirement. Another problem is that some banks put a cap on the maximum tenure and it may not be possible to increase it beyond 20 or 25 years.

Prepayment of the loan

This means paying a lump-sum which reduces your outstanding balance so that your EMI doesn't rise even after taking into account the higher interest rates.

For example assuming you have Rs. 15-lakh loan for a 20-year term at an interest rate of 12%, your indicative EMI would be around Rs. 16517. If the interest rate inches up to 13%, you would have to pre-pay around Rs. 90,000 to retain the same EMI and tenure.

Raising that kind of cash may be difficult case since you have already stretched yourself to buy that dream home. In that case, you may have to liquidate some of your investments or pledge financial assets such as an insurance policy or national savings certificate and receive an overdraft facility that will allow you to make the pre-payment.

A couple of things to look at if you do choose to pre-pay:

Check if there is any penalty for the partial pre-payment of your loan.

Take into account the loss of tax benefits because your tax-deductible interest payments are lower after pre-payment.