A common question that is asked these days by home loan borrowers is – Should I prepay my home loan? The trigger for this question normally arises because the loan consumer has some windfall cash inflows (like an annual bonus or sale of some shares etc).
They typically get conflicting advise on whether to prepay their home loan or invest the sum in some other financial instruments. The most common is that home loan interest is tax deductible and hence it is a cheap loan and you may be better off investing that money somewhere else to get a better return rather than repaying the home loan.
These complicated post tax calculations make sense for only a few high-end savvy consumers who in any case have access to expertise to solve this dilemma. If you also wish to do such a calculation you can use the, Should I pre-pay my loan calculator on this link.
For other consumers as a rule, it is always advisable to pre-pay any loan, including home loan, if you have spare cash. The only exception to this would be (1) if the borrower has taken fixed rate home loan in 2003 at around 7-8%. or (2) the borrower has very little cash to spare for emergencies (normally should be around 4-6 months expenses).
A common misunderstanding that sometimes trips a prepayment decision is the fact that the principal amount outstanding has not fallen substantially, even after making EMI payments for 3 to 4 years. For example in most 20 year loans only around 10% of the loan would have been repaid at the end of 3 years.
This is because the borrower is paying back a higher proportion of interest in the initial EMIs. The interest component could be anywhere near 80% in the initial months. Interest component comes down and principal component increases as a proportion of the EMI as the loan tenure matures.
This often leads to a common mistake of assuming that it is better not to prepay, say, after half way through the loan tenure, because the interest component is low now. But the fact is that the interest outgo as a percentage (which is what the interest rate is) on outstanding principal is the same whether it is after the 24th month or after the 120th month.
As interest rate on home loans is calculated using reducing balance method, the interest rate is always calculated on the remaining outstanding principal. As the remaining outstanding principal will be lower after 120 months compared to after 24 months, the interest amount which needs to be apportioned across the remaining tenure would also be lower, resulting in lower interest component. But the interest rate on the remaining principle would be the same at both the time period.
So the decision to repay one’s home loan should not be driven by the stage of your loan tenure but by prevailing interest rate and availability of cash with you.