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Why you should not prepay your home loan

Last updated on: May 26, 2010 14:33 IST

Why you should not prepay your home loan

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Presha Investments

This will be one of the most technical articles till date. So to make it read better let's make it simple by taking an example.

Rahim Ali, 34, has taken a home loan from a leading finance company and is paying an equated monthly instalment (EMI) of Rs 24,000 on loan tenure of 20 years.

He is overwhelmed by the interest amount that he paid in the third year and decides to prepay the loan at the end of the fourth year.

Let us take a moment here to understand how financial institutions charge EMIs on the loan you avail from them. As you will see in the table in the next slide your EMI amount in the initial years comprises of higher interest amount and lower principal amount.

As time passes by the principal component increases and the interest component decreases.

Presha Investments guides budding investors understand the complex financial details of various investment instruments.


Photographs: Rediff Archives
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Why you should not prepay your home loan

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Here are the details of Rahim's loan:

Loan amount: Rs 24 lakh

Rate of interest: 10.5 per cent per annum

Installment amount per month (EMI): Rs 24,299

Annual payment made through EMIs = Rs 24,299*12 = Rs 2,91,588

Note how the interest paid goes on decreasing and principal amount increases as time passes by. For instance in the first year of loan repayment Rahim paid Rs 2,52,000 as interest and Rs 39,588 as the principal amount out of his total annual payment of Rs 2,91,588.

However, if he were to continue repaying his loan (we have assumed that he decides to pay his loan off at the end of fourth year) then his interest amounts to Rs 52,760 and principal at Rs 2,38,828.

Now let's look at his yearly amortisation (Detail of his payment and its components like interest and principal) schedule:

Year (A) Principal Outstanding (B) Interest paid in year A Principal paid in year A (D) Total EMI Paid in year A (E) = C+D Closing balance of principal (F) = B-D
1 Rs 24,00,000 Rs 2,52,000 Rs 39,588 Rs 2,91,588 Rs 23,60,412
2 Rs 23,60,412 Rs 2,47,843 Rs 43,745 Rs 2,91,588 Rs 23,16,667
3 Rs 23,16,667 Rs 2,43,250 Rs 48,338 Rs 2,91,589 Rs 22,68,329
4 Rs 22,68,329 Rs 2,38,175 Rs 53,413 Rs 2,91,590 Rs 22,14,916
5 Rs 22,14,916 Rs 2,32,566 Rs 59,022 Rs 2,91,591 Rs 21,55,894
6 Rs 21,55,894 Rs 2,26,369 Rs 65,219 Rs 2,91,592 Rs 20,90,675
7 Rs 20,90,675 Rs 2,19,521 Rs 72,067 Rs 2,91,593 Rs 20,18,608
8 Rs 20,18,608 Rs 2,11,954 Rs 79,634 Rs 2,91,594 Rs 19,38,974
9 Rs 19,38,974 Rs 2,03,592 Rs 87,996 Rs 2,91,595 Rs 18,50,978
10 Rs 18,50,978 Rs 1,94,353 Rs 97,235 Rs 2,91,596 Rs 17,53,743
11 Rs 17,53,743 Rs 1,84,143 Rs 1,07,445 Rs 2,91,597 Rs 16,46,298
12 Rs 16,46,298 Rs 1,72,861 Rs 1,18,727 Rs 2,91,598 Rs 15,27,571
13 Rs 15,27,571 Rs 1,60,395 Rs 1,31,193 Rs 2,91,599 Rs 13,96,378
14 Rs 13,96,398 Rs 1,46,620 Rs 1,44,968 Rs 2,91,600 Rs 12,51,410
15 Rs 12,51,410 Rs 1,31,398 Rs 1,60,190 Rs 2,91,601 Rs 10,91,220
16 Rs 10,91,220 Rs 1,14,578 Rs 1,77,010 Rs 2,91,602 Rs 9,14,210
17 Rs 9,14,210 Rs 95,992 Rs 1,95,596 Rs 2,91,603 Rs 7,18,614
18 Rs 7,18,614 Rs 75,454 Rs 2,16,134 Rs 2,91,604 Rs 5,02,480
19 Rs 5,02,480 Rs 52,760 Rs 2,38,828 Rs 2,91,605 Rs 2,63,652
20 Rs 2,63,652 Rs 27,936 Rs 2,63,652 Rs 2,91,606 Rs 0
Total Rs 34,31,760 Rs 23,99,730 Rs 58,31490  

Say he makes prepayment at the end of fourth year. The table below shows the amount Rahim would save:

Principal paid at the end of the 4th year Rs 2,44,106
Principal outstanding (Prepayment amount) Rs 22,14,916
Years remaining 16
EMI saved Rs 46,65,408 = Rs 2,91,588*16

Now presuming that he would have taken help from a financial advisor and instead of prepaying the loan he had invested the principal amount unpaid at the end of fourth year (Rs 22,14,916) in say an Index Fund as bulk investment it would have yielded 26.85 per cent (compounded)* return. Rahim would have made Rs 12  crore even after deducting amount saved in EMIs (Rs 46,65,408) if he would have chosen to invest in an index fund over prepaying.

Principal invested Rs 22,14,916
Average rate of return on Index Fund (CAGR)* 26.85 per cent
Years invested 16
Amount* Rs 12,47,13,626

I am sure a lot of readers would wonder if at all it is always possible to earn returns of 26.85 per cent. While this may not be possible always Rahim would have made Rs 1.01 crore even if his investments had made profits at a conservative estimate of around 10 per cent compounded annually as shown in the table below.

Principal invested Rs 22,14,916
Average rate of return on Index Fund (CAGR)* 10 per cent
Years invested 16
Amount* Rs 1,01,77,479



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Why you should not prepay your home loan

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To every rule there is an exception though.

Here's when it would make sense for you to prepay your home loan:

  • When you are expecting uncertainty in your source of income with which you are making your EMI payment
  • When you are getting a better re-financing deal in spite of the prepayment penalty
  • When the loan tenure is less (say two years) then the risk is high in markets and there is less compounding

Having made the case for non-prepayment let me tell you that you might be an exception to the rule. Let your financial planner decide what's best for you.

Notes:

1. For calculating returns we have taken an Index Fund from SBI which is the oldest private fund house; this is just an example and not a recommendation

2. Index Funds are less risky than diversified equity and sector funds

3. In the above calculations we have not considered the benefits of deduction one can get under Section 80C on payment of principal and interest for continuing the housing loan

4. The returns calculated in the tables in slide 2 are based on the formula of future value.



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