Prepayment versus increasing tenure

Needless to say,the impact will be good in the short term as this step will reduce the EMI significantly. However,borrowers have to think of the long term implications especially the increased interest outflow on account of increased tenure.

For example,typically for home loan borrowers who took a loan in their 30s,a tenure increase would mean that they will have to keep paying the loan even after retirement. This EMI burden will be difficult to fulfil with advancing age when there is no source of income. Moreover,as borrowers grow older,the expenses will only increase. They would have to decide whether they will be comfortable taking on such a burden for the next 20-30 years.

The second point is increased outflow of interest. Increase in tenure comes at a cost. Lets look at the extra burden imposed by longer tenures.

Prepaying versus increasing tenure

Recently,the National Housing Bank sent a directive to home finance companies not to charge prepayment penalty. This will enable borrowers to do their research on refinancing rates and arrive at a cost saving decision. Even if the advantage is 1 per cent,this can help them save a good amount of money in the long term.

Refinancing: Borrowers can prepay their existing lender through loan refinance from other lenders,who provide loans at more attractive interest rates. Since the prepayment penalty is no longer applicable,borrowers can prepay without worrying about the complex prepayment structure and high charges.

Prepayment from own sources: Borrowers can also use their savings,bonuses,passive income sources or liquidated assets to prepay the loan. Do remember that it is not essential to prepay in one go. To save on interest cost,partial prepayments go a long way in reducing interest outgo and you should utilise this to the maximum to pay the loan early.

How to Prepay in short intervals:

You need to keep your loan amount less burdensome compared to the income,which will allow you to part prepay at intervals. You should start prepaying as early as possible to be able to close your loan quickly and to counter consistent rate hikes. The thumb rule is that loan EMIs should not exceed 30-45 per cent of monthly income.

Heres what you can do:

Step 1: Check with your bank at what point during the loan tenure you can start prepayments.

Step 2: Set aside 10 per cent of your income for home loan repayment.

Step 3: Accumulate this amount every three months and make a quarterly prepayment.

Here is an illustration of how part prepayment from your own sources can help you close the loan early.

Given below is a scenario,where post rate hike an individual has to repay a loan of Rs 20 lakh in 15 years at 12 per cent,the EMI being Rs 24,000.

Here,the total interest due would turn out to be Rs 23,21,680.

Now let the individual save a portion of his earnings towards prepayment and ends up paying two extra EMIs annually,i.e.

Rs 48,000.

Let us divide the two extra EMIs uniformly across the year at the same rate of interest. So it becomes Rs 24,000 Rs 4,000,that is Rs 28,000.

Any good loan calculator available on the internet will show that the loan tenure is reduced to around 10 and a half years after the two extra EMIs in a year.

The total interest due in this case would be Rs 15,25,200,a substantial saving.

The added advantage of prepaying the home loan,if you can manage it within your income,is that you will retain complete ownership of the house earlier than planned. The longer the loan tenure,greater the interest repaid.

Increase in tenure may look better in short term but hugely dents your savings. Even if you do opt for it,do remember to prepay in regular intervals,to close the loan much before the tenure as this amount is directly deducted from your outstanding principal amount. l

The author is CEO,BankBazaar.com