How to reduce home loan interest burden by smart prepayments

Dev ashish

With the banks in a hurry to pass on the RBI rate hikes to borrowers, the interest burden for home loan borrowers has increased substantially. Till early last year, home loans were available at mid-6%. But now, its common to see interest rates breaching the 9% barrier, even for those with good credit scores and repayment capacity.

In floating-rate home loans, banks are free to change the rates of existing borrowers as well. So, when the interest rates rise, the banks first try to keep the EMI the same and instead, increase the loan tenure. Social media these days is full of people sharing experiences where they took a home loan of 20 years and now with rate hikes, the tenure has increased to 30-35 years as the banks didn’t increase the EMI automatically.

An example will make this clearer. Suppose you took a loan of Rs 40 lakh at 6.75% last year for 15 years. The original EMI was Rs 35,396. Now due to interest rates being increased by the banks, your home loan rate has increased to 9.25%. In this case, the bank will not automatically increase your EMI. It will keep the EMI the same as earlier, ie, Rs 35,396 and instead allow the loan tenure to increase, which will now be almost 21-22 years (instead of 15 years originally).

How to prepay smartly to reduce interest burden

With new and old home loan rates crossing 9% for the most borrowers, it has surely become quite costly from an increased interest cost perspective. And since most of the relatively safe savings options offer lesser returns (6-7%) than home loan rates (almost 9-10% for many), there is definitely a case to start prepaying your home loans if you can comfortably manage it.

Mathematically, the best time to prepay a home loan is the earlier you can in the tenure. So, if you have a Rs 50 lakh home loan for 20 years, then it is better to make a prepayment (of say Rs 5 lakh) in the third year instead of the 12th year. And the reason is home loans are structured in a manner that during the initial years, the interest component in EMI is larger. And this gradually decreases later in the tenure.

And hence, the bigger impact on the interest burden reduction comes if you prepay earlier.

Here are a few pointers to help you get going with this

1) You may be tempted to use old FDs (earning 5-6%) that you set aside as emergency fund, to make the prepayment. But don’t do that. Never use it to make prepayments. Emergencies don’t wait for anything or anybody and come unannounced. So, keep an emergency buffer at all times.

2) If your income (after all expenses) allows, then consider increasing your monthly EMIs immediately. For example, you took a Rs 40 lakh loan recently at 9% for 20 years. Your monthly EMI would be Rs 35,989. Now if you can increase the EMI by say about Rs 4000 and start paying Rs 40,000 monthly, then the loan interest burden reduces by almost Rs 12 lakh and the loan also gets over in 16 years instead of 20. So just paying a bit extra every month can also go a long way in reducing your interest burden.

3) Another option can be to do one-time lumpsum prepayment. We have already set aside an emergency fund. Now in addition, if you have surplus money in say savings account or low-interest FDs, etc., then you can use a part of it to make some prepayments. This will immediately reduce your outstanding principal and help negate the rate hike to some extent.

4) In addition, you can also consider increasing your monthly EMIs by 5-10% each year as your income increases. This accelerates loan closure.

5) You can also use a part of your annual bonus to prepay every year. Or let’s say you should try to pay an extra 1-2 EMIs each year in one go if you have access to some surplus money.

Note - While there is a tax angle to the discussion as well, the fact is most people would want to get rid of their home loan quickly. So, the above discussion is directed more towards those borrowers.

The rate hikes in recent months have been sharp and brutal. And there is no doubt that if borrowers don’t make some prepayments now, then their interest burden will increase substantially. So go through the above points once more and if you can, then try to implement at least a few of them to negate the impact of rate hikes.

(Dev Ashish is a SEBI-registered investment advisor and founder of Stableinvestor.com, who provides fee-only investment advisory services)