Interest rates on loans have fallen to decadal lows. The lowest advertised home loan rate at the moment is 7.95 per cent per annum. So, it is not just a good time to take new loans but also to make pre-payments. There are clear benefits in pre-paying while the rates are low. But what are the charges? What will be your savings? Wouldn’t it be better to just hold on to your savings in an economic slowdown? Let us examine your options.
What to do with savings?
Pre-payment of loans is an option only when you have surplus liquidity. You may use the pile of cash you are sitting on to reduce your loan balance. You could also pre-close the loan, which could free up the part of your income tied to EMIs.
The big question here, however, is how much of your liquidity you should give up in order to reduce your liabilities. In an economic slowdown, one must use their cash reserves carefully. Even though this is a buyer’s market and prices are low, losing all your liquidity can be a problem.
For example, if you were to lose your job, with cash in hand it would still be easy to manage your EMIs and other major expenses. Therefore, a smart way to approach pre-payment in such a situation would be to maintain cash reserves for an optimum level of financial stability. Beyond that level, use your surplus to reduce the loan balance.
But what is an optimum level? There is no one-size-fits-all response to this. Your emergency fund should be worth at least 3-6 times your current monthly income. This fund should help you tide over a financial crisis such as loss of income.
What if you prepay?
Loans come in many variants —home, car, personal, education and business. With regard to pre-payment and pre-closure, each loan product has its unique norms. These norms vary not just from one loan category to another but also from one lender to another.
Home loans with floating rate interest rates do not have pre-payment or pre-closure charges. However, fixed-rate home loans do. So do car and personal loans. Before you pre-pay on these loans, check with your lender about the charges. For example, if you take a personal loan from a leading private bank, you cannot pre-pay during the first 12 months of your loan tenure. Between months 13 and 24, pre-payment will attract a charge equal to 4 per cent of the loan balance plus taxes, 5 per cent between months 25 and 36, and 2 per cent from the 37th month.
Also, you will need to meet your lender’s minimum pre-payment norm (such as pre-paying at least one EMI’s worth). However, unlike an EMI payment which consists both of principal and interest payment, a pre-payment is only against the principal and not the interest, which works to your benefit. So, for example, if you pre-paid Rs 50,000 towards your home loan, your loan balance will reduce by that extent.
What do you stand to gain?
Any time you pre-pay or pre-close a loan, you must always evaluate what you stand to gain. If your gains — the overall reduction in interest — are larger than your costs, you should go ahead with the pre-payment.
In calculating your gains, you must also pay attention to the impact on tax benefits. For example, if your home loan principal is below the Rs 1.5 lakh limit under section 80C, you may want to make up the shortfall by prepaying more of your principal to get the full tax benefit under 80C.
In fixed-rate loans, often the disincentives are sizeable, which can make pre-payment unattractive. Therefore, use an online loan calculator and understand what you stand to gain. That said, gains from pre-paying home loans are often sizeable, and this you should consider strongly especially if you are in the first half of your loan tenure. In the second half, you may want to hold on to the loan longer to keep getting useful tax deductions.
You could potentially save lakhs of rupees by pre-paying just one EMI’s worth. Not just that, pre-payment while interest rates are low is more beneficial than doing so at higher rates, because it makes a tremendous impact on reducing the costs of borrowing (i.e., the interest). Let’s understand this with some numbers.
Pre-pay while the rate is low
Assume you had taken a home loan of Rs 50 lakh at 8.7 per cent interest for 20 years. Your EMI is Rs 44,026, and your total interest is Rs 55.66 lakh. Remember that actual numbers will vary as in a floating rate loan the interest rate resets now and then.
So, you borrow Rs 50 lakh and repay Rs 1.05 crore over 20 years. Now, let us come to the EMIs. Assume you have paid 24 EMIs after which your total principal payment is Rs 2.03 lakh, while you’ve paid Rs 8.53 lakh in interest. Your loan balance is now Rs 47.96 lakh. With your 25th EMI, you decide to pre-pay a little over 5 per cent of your loan balance, or Rs 2.5 lakh. This reduces your interest to Rs 47.32 lakh, saving you a whopping Rs 8.34 lakh and also reducing your loan tenure to 216 months, or 24 fewer EMIs.
Now, let’s assess the impact of the same pre-payment if it was done at a lower interest rate of 8.4 per cent. At this point, your total interest (including that already paid) is Rs 53.74 lakh. If you pre-pay Rs 2.5 lakh with your 25th EMI, your total interest falls to Rs 45.91 lakh, which is an additional savings of Rs 1.41 lakh compared to pre-paying while the rate was at 8.7 per cent. And so the more you pre-pay at lower rates, the more you will save in the long run.
And this is why it is in your interest to exploit low-interest rates. Use the cycle to your advantage and make pre-payments, especially on your home loan. This will help you move out of debt. If you are pre-paying a fixed-rate loan, always assess the gains against the pre-payment penalties.
The writer is CEO, `BankBazaar.com`