Home Loan Prepayment: Key factors to keep in mind before prepaying your home loan

The big-ticket size and long repayment tenures of up to 15-30 years make home loans one of the biggest financial commitments of our lives. This also results in home loan’s interest cost often exceeding the loan’s principal amount. Hence, many home loan borrowers try to reduce the overall interest cost by making partial prepayments during the repayment tenure. Home loans lent on floating interest rates usually do not attract prepayment penalties.

However, before prepaying your existing home loan, consider these factors to maximize the benefits of your prepayments.

Reduce EMI or tenure?

While prepaying their housing loan, borrowers usually have two options. They can either reduce the loan tenure or the EMIs. While loan tenure reduction will result in greater savings in the overall interest cost, opting for the EMI reduction option would lead to higher disposable income for the borrowers.

The decision to choose between these two options primarily depends on what the borrower wishes to prioritize – reducing the overall interest cost or reducing their EMI burden for undertaking investments and expenditures.

Compare savings from home loan balance transfers

Home loan balance transfer (HLBT) refers to transferring the existing home loan to another lender at a lower interest rate and/or at better terms and conditions. This facility helps the existing home loan borrowers to avail housing loans at much lower rates owing to their improved credit profile and declining interest rate regime.The lower interest rate availed on exercising HLBT will reduce the overall interest payout without impacting the borrower’s liquidity and existing investments. Hence, existing home loan borrowers should first explore the scope of savings on transferring their home loans to other lenders at a lower interest rate.

Borrowers opting for home loan balance transfer can opt for the home loan overdraft option, a housing loan variant if offered by a new lender. Under this facility, an overdraft account in the form of savings or current account is opened and linked with the home loan account. The borrowers can deposit their surplus funds in this overdraft account and later withdraw from it to deal with fund shortage or other monetary requirement. While calculating the interest component, the balance of this overdraft account is deducted from the outstanding home loan amount.

Never use your emergency fund for loan prepayment

The primary objective of maintaining an emergency fund is to tackle financial exigencies and/or meet unavoidable expenses like existing EMIs, insurance premiums, rent, children’s tuition fee, etc during periods of income loss caused by job loss, illness or disability. Ideally, the size of an adequate emergency fund should be large enough to meet unavoidable expenses for at least six months. Hence, using your emergency fund to make prepayments on your home loan can put you in a difficult situation. It may force you to take out loans at much higher interest rates or sell off other investments at less favorable prices to handle financial emergencies or unavoidable expenses during times of lost income.

Avoid redeeming investments meant for crucial financial goals

Many home loan borrowers tend to redeem their existing investments earmarked for crucial financial goals to make prepayments. However, doing so can not only adversely impact their liquidity and long-term financial health, it may also force them to avail costlier loans to achieve crucial financial goals.

Factor in the returns generated from existing investments

Although home loans have one of the lowest lending rates among all retail loan products, their interest rate can still be higher than the returns generated by most fixed-income instruments. Hence, home loan borrowers having surpluses parked in fixed income products such as fixed deposits, short-term debt funds, etc. which are not earmarked for any crucial financial goal, can utilize them for prepaying home loans.

In the case of equity investments, this relationship will change.As the long-term returns generated by equity investments usually beat the interest rates of home loans by a wide margin, one should avoid disturbing one’s equity investments and continue to remain invested in them for the long-term wealth creation.

Final Words

Home loan borrowers considering prepayment should choose the EMI reduction option if they want lower EMIs and increased disposable income. On the other hand, borrowers seeking higher savings in the overall interest cost need to avail the tenure reduction option.