Should you prepay?

Given the Indian aversion to debt, home loan borrowers often prefer to prepay. However, this is not always the most economical option and one should consider various factors before deciding on this course.

The incentive for prepaying a home loan is often the lower interest rate on offer. Let us consider a home loan taken at 7.5 per cent in 2005. Banks increased the reference rates in 2008 and then reduced these later that year and in 2009.

The net impact would have been a 2-6 percentage point increase in the interest rate. Today, the borrower would be paying 9-13 per cent on the same loan. As banks are currently offering loans at 8-10 per cent, borrowers would be tempted to shift.

However, the decision to replace an existing home loan with a new one should not be based on the interest rate alone. One should also take into account the amount and tenure left for repayment, and prepayment charges.

If you have spare cash, it is advisable to prepay any loan. This can substantially reduce the interest cost. In the case of home loans, if you do not reduce the principal outstanding amount on your loan, you may end up paying twice the amount you borrowed.

However, prepayment is not the right option if a fixed-interest loan has been taken at a rate lower than the interest rates offered on savings instruments, such as fixed deposits. Also, one should not prepay if the borrower enjoys substantial tax benefits in terms of repayment on the principal amount, under Section 80C.

Sometimes the decision to prepay is driven by the fact that the outstanding principal amount has not reduced substantially even after the payment of EMIs for 3-4 years.

For example, consider a Rs 30-lakh loan taken at an interest of 7.5 per cent for 20 years. If the borrower decides to prepay at the end of the fourth year, the principal would still be about Rs 27 lakh. This is because, in the initial stages, the interest amount accounts for a big proportion of the EMI.

This often leads to the wrong assumption that it is better not to prepay, say, halfway through the loan tenure because the interest component is low at this stage. The fact is that the interest to be paid as a percentage (that is, the interest rate) on the unpaid principal amount is the same.

The interest on home loans is calculated using the reducing balance method, which is based on the outstanding amount. Therefore, the decision to prepay should not be based on the stage of your loan tenure, but on the prevailing interest rates.

Apart from the interest rate, one should consider the charges for prepayment of the loan. More often than not, banks charge borrowers for closing the loan account before the stipulated time. If the saving on the interest is less than the prepayment penalties, it is better to complete the loan tenure.

The writer is Chief Executive Officer of GE Money India.