Most of us are averse to being debt ridden. A loan (of any type) is a debt that one would typically want to repay at the earliest (preferably prepay i.e. pay before it’s due). Prepayment is a facility which allows you to repay your housing loan (in part or full) before the completion of your loan tenure. Usually, customers opt for prepayment when they have surplus funds. Evaluate the following factors before deciding to pre-pay your loan
Funding needs
Before considering prepayment of your housing loan, you need to ensure that you have sufficient funds for your living expenses or for financial goals such as marriage, travel abroad, etc. You should avoid being in a situation where you have overextended yourself to prepay your home loan and, as a result, are funds-strapped when you need to meet a financial goal. Moreover, you also need to ensure that you have surplus funds available for medical emergencies, or unforeseen events such as job loss.
Income from investments
The cost of prepayment should also be compared with the returns that can be earned from investments. If you have the opportunity to earn returns which are higher than the home loan interest, then it is better to invest the surplus funds rather than using the same to prepay your home loan.
A home loan is a long duration loan; in order to make an ‘apples-to-apples’ comparison of your home loan cost vis-à-vis a comparable investment, equity investment should be considered. Equity investment is a long term investment where the risk reduces in proportion to the period of investment, i.e. the longer you hold your equity investment, the lower will be the risk.
Stage of the loan
The main benefit of prepayment is the reduction in interest outflow. The interest component in the EMI is highest during the initial stage of the home loan. Therefore, prepayment of loans in the mid-to-late stage may not give you the full benefit of saving on interest. In such cases, it is prudent to invest the surplus funds.
Interest rate
Housing loans are easier to service – the interest rate on home loans is generally lower than the rate of interest charged on other loans such as personal loan or credit card loan. Therefore, if you want to reduce debt, it is better to prepay high interest-bearing loans on priority basis (as against housing loans which carry a lower rate of interest).
Tax deductions for home loan
You are entitled to claim tax exemption of up to Rs.1.50 lakh per financial year on repayment of principal amount of housing loan. You can also get tax exemption on interest paid on housing loans (exemption is up to Rs.2 lakh). Moreover, with the government’s focus on ‘housing for all’, the tax incentives on housing loans may increase over time. On full prepayment of your housing loan, you will no longer enjoy these tax benefits; in case of part prepayments, you will get lower tax benefits.
Prepayment charges
The decision to prepay your home loan should be considered after accounting for the cost of prepayment. While on adjustable rate home loans there are no prepayment charges, on fixed rate home loans, lenders usually charge a penalty of 2 percent of the amount being prepaid through refinance, i.e. when you borrow to prepay your home loan. However, if you use your own funds to prepay your housing loan, no prepayment penalty is levied.
The bottom line
As Indians, most of us are conditioned to think that debt is potentially troublesome. While it’s good to reduce debt, high aversion to debt is not always best alternative. Always remember, in a haste to prepay your home loan, do not compromise on liquidity. Ensure that you have sufficient funds available for your financial goals and emergency requirements.