Why it is better to prepay part of your home loan EMIs regularly

Take the case of Bengaluru-based Arghya Bhattacharya (42), an IT professional who had taken a ₹60 lakh home loan from a private sector bank for buying an under-construction flat in 2017. The interest rate on the loan was 8% at that time. He took possession of the flat in August 2019 and made a prepayment of about ₹10 lakh. During the pandemic, he transferred his loan to a public sector bank. He was charged an interest rate of 6.5%. But interest rates have been soaring since then and has gone beyond 9%. “The bank informed me about the revised rate only via mail but there were no details about the revised tenure or an option to increase the equated monthly instalments (EMIs)," says Bhattacharya.

Bhattacharya, though, plans to prepay the balance principal amount at the earliest. Not many borrowers will be able to do that unless they have a significant amount in savings.

Interest rates

“Borrowers are anxious about getting the maximum possible loan amount when they buy a new house," says Raoul Kapoor, co-CEO of Andromeda. And that is where the problem begins. When interest rates rise, lenders tend to increase the loan tenure and that is their default option. In cases where the principal loan amount is high, the tenure then stretches to several years. To be sure, the EMI consists of both interest amount and the principal. A major part of the EMI goes into paying off the interest and the remaining to clear the principal amount.

In the new scenario, the EMIs will barely cover the interest component of the loan amount. And any unpaid interest gets added to the principal. It results in a situation wherein the borrower is unable to repay the loan and defaults on payments. This phenomenon is called negative amortisation.

“Banks believe borrowers will not default on home loans and will try to close the loan as soon as possible by making prepayments. But, what if the borrowers do default? Negative amortisation is a systemic risk," says Deepak Shenoy, CEO at Capitalmind, a Sebi-registered portfolio manager.

Earlier this month, the Reserve Bank of India (RBI) issued two important circulars. One, all lenders, including non banking financial companies, must clearly communicate to borrowers about the possible impact of a change in the benchmark interest rate leading to higher EMI or increased loan tenure or both. Borrowers should be given a choice to pay a higher EMI or opt for a longer tenure, or a combination of both. They should also be allowed to prepay, either in part or in full, at any point during a loan tenure. Second, they should be given a chance to switch to a fixed home loan rate and vice versa whenever interest rates get reset.

“In effect, it means that banks will not allow negative amortisation any more. The EMI should be enough to cover the interest component at all times. The banks have time till December to get it done. It also shows a fairly large number of loans could be running at negative amortisation," Shenoy says.

The banking regulator may have observed this problem for some time before it came out with the current solution in its recent circulars, yet borrowers must keep themselves apprised of the interest change environment. It is better to do a careful analysis before deciding on the type of home loan rate—fixed, flexi or floating and the loan tenure. Yet, a higher loan amount will lead to problems when interest rates rise.

Prepayment

A rising interest rate environment highlights the importance of prepayment of home loans. If you prepay 5% of your loan balance once a year, you can close a 20-year loan in 12 years, says Adhil Shetty, CEO and co-founder, BankBazaar.com.

Anecdotal data says many borrowers tend to prepay home loans within 10 years. Yet, it is important to understand the prepayment procedure and the charges for this.

“In case of prepayment, there is the cost created by barriers to prepayment. For example, two lenders offer you a home loan at 8.5%. One says you can prepay a minimum of just one EMI. The other needs you to prepay a minimum of two EMIs. Despite the rates being the same, the second loan extracts higher interest because it’s tougher to pay," says Shetty.

Some banks such as SBI and Bank of Baroda offer you home loans like an overdraft (SBI Maxgain, Baroda Advantage) where you can use your surplus lying idle in savings account to reduce the loan outstanding. This helps in clearing the loan faster.

Another important aspect is keeping a buffer in your monthly cash-flows when you fix your EMIs. The EMI should not be more than 40% of your income. That is because even if the interest rates increase, you should be in a comfortable position to manage the higher EMIs rather than allow an increased loan tenure.

Eligibility criteria

The first thing to do before zeroing in on your property is to check your home loan eligibility. It will help you plan your budget accordingly. Do compare the interest rates offered by different lenders. The advantage of a fixed interest rate loan is that the EMIs will not rise in tandem with the rise in interest rates. On the flip side, the EMIs will not come down either when interest rates fall.

Borrowers have to submit various documents such as loan application form, salary slips of last three months, form 16 or income tax returns of the last two years and bank statement of the salary account. A self-employed individual needs to produce proof of the business .

A builder-buyer agreement is needed when the bank evaluates a loan application before it finally disburses the loan amount. “The due diligence is to check your ability to repay the loan and the asset for which you are taking the loan. Even if one’s credit score is good, the loan may get rejected if the builder is not credible," says Kapoor of Andromeda.

In case of a low credit score, having a co-applicant may help in fetching the loan.

Negotiate charges and offers

If your credit score is good, you may negotiate with the lender to reduce the processing fee and offer you the lowest possible interest rate. Besides, you must take note of late payment and prepayment charges, if any. Notably, RBI has specified in its latest circular that banks cannot levy a penal interest on loan defaults. They can only charge a penalty. Penal interest gets compounded and exponentially increases loan dues.

“The typical fees you pay during a home loan application process would be for processing, legal evaluation, documentation, and memorandum of deposit (MoD). All put together, it should be less than 1% of the loan, subject to lower limits. MoD charges, a statutory requirement, weigh heavily in the costs. Some lenders will discount the processing fee," says Shetty.

Fixed or floating rates

RBI has specified that a borrower can move to a fixed rate home loan and vice versa when interest rates switch and the loan agreement gets reset. There could be some charges involved in switching the loan but this will be clearly communicated by the lender at the time of sanctioning the loan. To be sure, fixed rates are always higher than floating rates. As per Data from BankBazaar, while floating rates for home loans at Axis Bank is 9-9.4%, the fixed rate is as high as 14%. Moreover, fixed rates are not really fixed for the whole tenure. They do go up with the change in market conditions.

“The switch option is welcome. Borrowers can lock the loan in fixed rate when benchmark rates are on an upward trajectory. They can move to floating when the rate cycle changes to downward trajectory. But it’s important to be mindful of switching charges. It is better to check with financial planners before you take a call on it," says Kapoor.

Home loan is a long-term obligation. One should understand the maths thoroughly before committing to it. RBI’s recent circulars will make the system more transparent but seeking clarity is the borrower’s job.