Introduction to home loan prepayment
Home loan or housing loan is a financial product that helps people to fulfill their dream of owning a house. A home loan is a long-term commitment and often involves a large sum of money. The repayment of a loan typically spans over several years, and the interest rates can vary based on market conditions. One of the common questions that borrowers have is whether they should prepay home loan. In this article, we will discuss the pros and cons of home loan prepayment.
What is home loan prepayment?
Prepay home loan refers to making a lump sum payment towards the outstanding principal amount of the loan before the scheduled due date. This can be done either in part or in full. Prepayment can be made at any time during the tenure of the loan. Most banks and financial institutions do not charge any penalty for prepay home loan.
Pros of prepaying home loan
1. Save on interest
One of the primary benefits of prepay home loan is the savings on interest. The interest component of a loan is typically higher in the initial years of the loan. By prepaying the loan, the borrower can reduce the outstanding principal amount, which, in turn, reduces the interest payable on the loan.
For instance, let’s assume that the outstanding principal amount of a loan is Rs. 50 lakhs, and the interest rate is 8%. The EMI for this loan would be Rs. 43,391, and the total interest payable over the tenure of the loan would be Rs. 57,74,877. If the borrower makes a lump sum payment of Rs. 5 lakhs towards the principal amount, the outstanding principal amount would reduce to Rs. 45 lakhs. The EMI would remain the same, but the total interest payable would reduce to Rs. 51,96,727. Thus, the borrower would save Rs. 5,78,150 in interest by prepaying the loan.
2. Reduced financial burden
Prepaying a home loan can help reduce the financial burden on the borrower. It reduces the monthly EMI payments, which can be used for other financial goals such as investing, savings, or paying off other debts. It can also help improve the borrower’s credit score, which can have a positive impact on their future borrowing prospects.
3. Peace of mind
Prepay home loan can give the borrower peace of mind. It eliminates the stress and anxiety of having a long-term debt and the uncertainty of future interest rate fluctuations. Prepaying a loan can also help the borrower become debt-free sooner, which can be a significant psychological relief.
Disadvantage of prepaying home loan:
1. Opportunity cost
Prepay home loan involves using a significant amount of money, which could be used for other financial goals such as investing or saving. By prepaying the loan, the borrower may miss out on potential investment opportunities that could generate higher returns in the long run.
For instance, let’s assume that the borrower has a home loan with an outstanding principal amount of Rs. 50 lakhs and an interest rate of 8%. The borrower has the option of prepaying the loan with a lump sum amount of Rs. 5 lakhs or investing the same amount in a long-term investment with an expected return of 10%. In the first case, the borrower would save Rs. 5,78,150 in interest by prepaying the loan. In the second case, the investment would generate a return of Rs. 10,44,180 over the tenure of the loan, which is higher than the interest savings from prepayment.
2. Tax benefits
Another potential downside of prepay home loan is the loss of tax benefits. Home loan borrowers are eligible for tax deductions on both the principal and interest components of the loan. The deduction on the principal component is covered under section 80C of the Income Tax Act, while the interest component is covered under section 24(b) of the same act.
If the borrower pre-pays the loan, the principal component will reduce, which will also reduce the deduction under section 80C. Similarly, if the borrower pre-pays a significant amount, the interest component of the EMI may also reduce, which may lead to a lower tax benefit under section 24(b).
3. Prepayment charges
Although most banks and financial institutions do not charge any penalty for prepay home loan, some lenders may charge a prepayment penalty if the loan is prepaid before a specific period. It is essential to check the terms and conditions of the loan agreement to determine if there are any prepayment charges applicable.
4. Liquidity
Prepaying a loan involves a significant amount of money, which could impact the borrower’s liquidity. It is important to assess the borrower’s overall financial situation before making a lump sum payment towards the home loan. If the borrower is facing a financial crisis or has other significant financial goals, prepay home loan may not be the best option.
Conclusion
Prepaying a home loan can have several benefits such as savings on interest, reduced financial burden, and peace of mind. However, it is essential to weigh the pros and cons carefully before making a decision. Loan borrowers should consider their financial goals, liquidity, tax benefits, and prepayment charges before deciding whether to prepay their home loan or not. If the borrower decides to prepay the home loan, it is recommended to plan the prepayment based on their financial situation and available resources.
In conclusion, prepaying a home loan can be an excellent option for borrowers who want to reduce their financial burden and save on interest. However, it is essential to consider the potential downsides such as the loss of tax benefits, opportunity cost, prepayment charges, and liquidity before making a decision. Home loan borrowers should carefully assess their financial situation and future goals before deciding whether to prepay their home loan or not.