Is this the right time to prepay your home loan?

Is this the right time to make good on your payments with a lumpsum? Here's how to make your decision. Illustration: Uttam Ghosh

A common question that is asked these days by home loan borrowers is: Should I prepay my home loan? The trigger for this question normally arises because the loan consumer has some windfall cash inflows (like an annual bonus or sale of some shares etc).

They typically get conflicting advice on whether to prepay their home loan or invest the sum in some other financial instruments.

The most common theory is that home loan interest is tax deductible and hence it is a cheap loan. So you may be better off investing that money somewhere else to get a better return, rather than repaying the home loan.

These complicated post-tax calculations make sense for only a few high-end savvy consumers who, in any case, have access to professional expertise to solve this dilemma. If you also wish to do such a calculation you can use the 'Should I pre-pay my loan?' calculator here: http://www.apnaloan.com/loan-advice-india/prepay-loan-calculator.html

For other consumers, as a rule, it is always advisable to prepay any loan, including a home loan, if you have spare cash. The only exception to this would be:

a) If the borrower has taken a fixed rate home loan in 2003 at around 7 to 8 per cent or

b) The borrower has very little cash to spare for emergencies (normally should be around 4 to 6 months' expenses).

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 (equated monthly installments) payments for 3 to 4 years.

For example, in most 20-year loans only around 10 per cent of the loan will have been repaid at the end of 3 years. 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 per cent in the initial months. Interest component comes down and principal component increases as a proportion of EMI as the loan tenure matures.

This often leads to the common mistake of assuming that it is better not to prepay, say, halfway through the loan tenure, because the interest component is low then. 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.

As the interest rate on home loans is calculated using the 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 will also be lower, resulting in lower interest component.

But the interest rate on the remaining principal would be the same at both the time periods.

So the decision to repay your home loan should not be driven by the stage of your loan tenure, but by prevailing interest rates and availability of cash.