Why prepaying a home loan is a very good idea

Prepaying a home loan is the best thing that a borrower can do. Most lenders will not tell you this because they don’t make money unless you pay them interest. The smartest way to save money is by closing your loans early, preferably through small and regular prepayments. 

Prepayment basics 

When you take a loan from a bank or a non-banking financial company (NBFC), it has to be repaid through easy monthly instalments (EMIs). 

The lender will deduct these EMIs from your bank account on a particular due date and all you need to do is to maintain a sufficient balance in your bank account. 

An EMI has two components, the principal and the interest. For example, if your EMI is ₹10,000, a part of this is going towards paying the interest on your loan and the remaining is going towards reducing your principal. This equation changes over time. 

The interesting part is that the interest component is higher in the initial years of the loan. This component keeps coming down as you progress towards the end of your loan tenure. 

How prepayment helps

Whenever you make a prepayment towards your loan, it directly goes towards reducing your outstanding principal amount. This is important. Big or small, any amount helps. 

This means, your next month’s interest will be calculated only on the remaining principal amount, which results in two very important outcomes. One, lower interest part and two, higher principal part - in the next EMI. 

This can help you reduce the interest component substantially for the remaining tenure of the loan and the principal getting repaid faster. 

The final outcome of your prepayment is that you end up closing your loan much earlier than you initially thought. 

So, prepayments are a really good idea but many-a-times, customers may not be aware or may forget to go for these. Regularized micro prepayments that get auto-debited from your bank account are, therefore, an option worth considering. 

Here’s an example to understand how prepayments can make a difference. 

Assume you have taken a loan of ₹20 lakh for a tenure of 20 years at 7.5% rate of interest.

Scenario 1 - Your monthly EMI comes to ₹16,111. You end up paying ₹38.7 lakh at the end of 20 years which means, your interest cost comes to around ₹18.7 lakh on a loan of ₹20 lakh. Now, when I put it this way, it seems quite a lot. 

Scenario 2 - With a regular monthly prepayment of ₹1,000, you end up saving ₹2.66 lakh on your interest cost. This is equal to 29 EMIs. That’s like becoming debt-free two years earlier just by putting aside ₹1,000 every month. 

Prepayments, rather, regular prepayments are a superpower for any borrower.

Points to note

There are two things that a borrower must consider before prepaying a home loan. 

One, the charges involved in prepayment. If you have taken a floating rate loan, financial institutions cannot charge you for prepaying the loan. But, if you have opted for a fixed-rate loan, then there can be a charge for prepayment. So, take note of this. Two, one must prepay the most expensive loan first. 

For example, if you have taken a personal loan or a car loan in addition to a home loan, prepay the one with the highest interest outflow first. 

A home loan is a long-term commitment. When you decide to take it, choose your lender wisely. Ask them about prepayments and the policies around them. Ensure you can do the prepayment transaction easily from your phone like you do everything else in your life.

Manoj Viswanathan is MD & CEO, Home First Finance Company India.