Fiscally Fit
To pre-pay or not…
SHYAM P.
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It does not always make sense to pre-pay a home loan. Some tips to help you make the right decision…
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I took a home loan four years back. I want to make extra repayments in addition to EMIs when I have money to spare. Does it make sense to pre-pay? What is the best time period to pay the extra amount?
Dr. Raju Manthalkar
Following are some tips to help you decide:
Interest rate
If you have taken a fixed rate loan, at less than 10 per cent interest, then you are in a fairly sweet situation with no urgency to repay — unless there is a “reset clause” in your loan documentation, i.e., the right of the lender to revise the rate in the event of significant increase in the prevailing interest rate environment, such as now! Many PSU banks and a few private banks are able to offer competitive rates because of the reset clause.
If your loan is not a pure fixed rate loan, i.e., either part fixed-part variable or fully variable, then again you are under the risk of rate increase and have a strong incentive to pre-pay.
Prepayment penalty
This is one of the most hypocritical schemes. If the banks want to raise the EMI in the middle of the loan, they don’t seem to have any problem in doing so; but God forbid — you want to voluntarily pay more than your EMI — then they act as if hell’s broken loose and slap a penalty!
Well, the good news is, you can negotiate. Prepayment penalties are not written in stone. Prepayment penalties can be reduced or even waived if you have a good credit history (and take a printed copy of this article to the bank manager)
Many banks also have prepayment limits, which lays down the maximum prepayment possible in a year without penalty. If your extra payments are within the limit, you can get away free. As a rule of thumb, if you are in a variable rate loan, it makes sense to consider pre-payment if the penalty is less than two per cent.
Other debt (loans)
If you have any unsecured debt (credit card or personal loan), pay it off at once. To my best understanding, home loans are the cheapest loans available in the market. So — as a prudent decision — it can wait until other debt is cleared off.
Margin of cushion
Before you prepay, keep some money in liquid instruments to meet unforeseen contingencies and any family commitments expected over the next three to four years. Remember that once you prepay a housing loan, that money cannot be borrowed back easily later on. You may take a second home mortgage loan/ line of credit by pledging the equity in your home, but such loans are usually more expensive than your first home loan.
Alternate investment avenue
In case your home loan interest rate is significantly lower than the going rate in the market today and you are sure that your interest rate is locked-in (fixed), then you can adopt the following strategy to earn higher returns, albeit at your own risk.
Since you have access to cheap capital through your fixed rate loan, you may think about keeping the loan going and invest any extra cash-flow in an alternate investment — which you believe will fetch higher returns than your cost of capital, i.e., your home loan interest rate multiplied by (1- tax rate).
I am tempted to suggest the equity market as an alternate investment avenue, given the current levels but you can choose any investment avenue as long as the expected returns exceed your cost of capital.
You may feel that you are losing out on your tax rebate if you prepay. But, as discussed in my previous columns, this is not true. Firstly, the principal repayment portion of your tax rebate can be availed of through other investment schemes. Secondly, the interest portion of the tax rebate merely reduces the cost of interest and does not shield you in any way from incurring the interest expense in the first place.
Timing
Some people think that it may be beneficial to prepay the home loan only early in its tenure and not after it has passed the mid-way mark. This is untrue (may I say even ridiculous) Even though it is a fact that the EMI in the early years of the loan consists of mainly the interest portion and the EMI in later years consists of mainly the principal portion, the effective cost of the loan remains the same. At any point of the loan, the interest is applied on the POS (principal outstanding). Any prepayment will reduce the principal outstanding and hence the interest expense, which is always good. Hence your decision to prepay should not change based on how much tenure of the loan has already elapsed.
This is a fortnightly series on personal finance. Email your queries to: shyamscolumn@gmail.com
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