What does prepayment of loan mean? How can it help you save interest and reduce the loan tenure

Various home loan prepayment options (such as increasing your EMI by 5%-10% annually or making partial prepayment of Rs 50,000 or Rs 1,00,000 annually) can reduce your interest payment and loan tenure significantly.

Home loan: Why it makes sense to increase the EMI or make partial prepayments

Owning a home is one of the biggest aspirations of any individual. However, considering the high real estate prices, most people cannot buy their house on a down payment. They have to rely on home loans, and that too for a long tenure lasting up to 20 years. This article will explain how an individual can pay off their home loan ahead of time by means of various home loan prepayment options.

What is home loan prepayment?

A home loan tenure can be anywhere between 5 and 20 years or even more. Most people go for the maximum tenure they are eligible for so that they can keep the Equated Monthly Instalments (EMIs) as low as possible.

Home loan prepayment is the process of settling the home loan before the usual tenure of 20 years. It can be done using various home loan prepayment options such as increasing the EMI or making lump-sum prepayments, or both. It is crucial to note that as per RBI guidelines, banks cannot levy any foreclosure charges/prepayment penalties on any floating rate home loan to individual borrowers. So, if you have any surplus funds, partial prepayment of your home loan makes a lot of sense.

Home loan prepayment options

Let us assume Amit takes a home loan of Rs 50 lakh at an interest rate of 6.75% p.a. for a tenure of 20 years. He will be paying an EMI of Rs 38,018. Amit’s total payment in 20 years will be Rs 91,24,365, which includes a principal repayment of Rs 50 lakh and an interest payment of Rs 41,24,365.

While repaying the home loan, Amit has two options: Either continue paying the regular EMI for 20 years, or choose from one of the various home loan prepayment options. In this article, we will discuss four prepayment options:

  • 5% annual increment in EMI
  • Rs 50,000 prepayment at the end of each year
  • 10% annual increment in EMI
  • Rs 1,00,000 prepayment at the end of each year

Let us examine how each of the above prepayment options will work, and what benefits Amit will derive by opting for them.

Related: Know Your EMIs In-And-Out. Are You Paying More Than You Should?

1) 5% annual increment in EMI

Most people get an annual increment in their salary during their performance appraisal. They can use the additional monthly cash flow to increase their home loan EMI. 

For instance, Amit can increase his monthly EMI at a compounded rate of 5% at the start of each year. In our example, he starts with an EMI of Rs 38,018. Starting from the second year, he can increase the EMI by 5% every year as follows: 

  • Second-year EMI: Rs 39,919
  • Third-year EMI: Rs 41,915
  • Fourth-year EMI: Rs 44,011
  • Fifth-year EMI: Rs 46,211 and so on.

By opting for a 5% annual increment in EMI, Amit can avail of the following benefits on his home loan:

  • Reduction in the number of EMIs: Amit will be able to finish the home loan in 152 EMI instalments instead of the regular 240. This saves him 88 EMI instalments.
  • Interest savings: Amit will be paying an interest of Rs 27,71,482 instead of the regular interest of Rs 41,24,365. He will therefore be saving Rs 13,52,883 on interest payment.
Table: Benefit of 5% annual increment in EMI

2) Rs 50,000 partial prepayment at the end of each year

Many people get an annual bonus as part of their performance appraisal or Diwali bonus. They can use this lump sum to make an annual partial prepayment of their home loan. Also, some banks may not allow an increase in EMI, as discussed in the earlier section. In that case, a home loan borrower can set some money aside every month in a recurring deposit. 

Amit can use his annual bonus to make a partial prepayment of his home loan. If he doesn’t get any annual bonus, he can start a recurring deposit of Rs 4000 a month in a bank. At the end of 12 months, he will have Rs 48,000, plus the interest. He can add the shortfall, if any, from his pocket and make it Rs 50,000. Every year, Amit can use this Rs 50,000 to make a partial prepayment towards his home loan.

By opting for Rs 50,000 annual partial prepayment at the end of each year, Amit will derive the following benefits on his home loan:

  • Reduction in the number of EMIs: Amit will be able to finish the home loan in 198 EMI instalments instead of the regular 240. This will save him 42 EMI instalments.
  • Interest savings: Amit will be paying an interest of Rs 33,08,561 instead of the regular interest of Rs 41,24,365. He will therefore be saving Rs 8,15,804 on interest payment.

Note: At the time of payment of a lump sum prepayment, a borrower can choose to either reduce the loan EMI or the loan tenure. In the above example, it is assumed that Amit has opted to keep the EMI constant and chosen to reduce the loan tenure.

Table: Benefit of Rs 50,000  partial prepayment at the end of each year

3) 10% annual increment in EMI

Some people who are doing exceptionally well in their careers or working in sunrise industries get a higher annual salary increment compared to others. These people can afford to increase their home loan EMI at a compounded rate of 10% p.a. instead of the 5% p.a. discussed in the earlier section.

Let us see what will happen if Amit increases his monthly EMI at a compounded rate of 10% p.a. at the start of each year. For example, he will start with an EMI of Rs 38,018. Starting from the second year, he can increase the EMI by 10% every year as follows: 

  • Second-year EMI: Rs 41,820
  • Third-year EMI: Rs 46,002
  • Fourth-year EMI: Rs 50,602 
  • Fifth-year EMI: Rs 55,662 and so on.

By opting for a 10% annual increment in the EMI, Amit will derive the following benefits on his home loan:

  • Reduction in the number of EMIs: Amit will be able to finish the home loan in 120 EMI instalments instead of the regular 240. This will save him 120 EMI instalments.
  • Interest savings: Amit will be paying an interest of Rs 22,58,003 instead of the regular interest of Rs 41,24,365. He will therefore be saving Rs 18,66,362 on interest payment.
 Benefit of 10% annual increment in EMI

Related: 5 Reasons To Go For Home Loan Refinance

4) Rs 1,00,000 partial prepayment at the end of each year

As mentioned earlier, many people get an annual performance-based bonus or Diwali bonus. They can also start a recurring deposit of Rs 4000 per month to accumulate Rs 50,000 every year. Clubbing the annual bonus and recurring deposit maturity amount will create a fund of Rs 1 lakh every year. 

If you don't get an annual bonus, you can start a recurring deposit of Rs 8000 per month to accumulate Rs 1 lakh at the end of the year. This amount can be used to make a partial prepayment of Rs 1 lakh on the home loan at the end of each year.

Let us see what will happen if Amit makes an annual partial prepayment of Rs 1,00,000 on his home loan at the end of each year. He will derive the following benefits:

  • Reduction in the number of EMIs: Amit will be able to finish the home loan in 168 EMI instalments instead of the regular 240. This will save him 72 EMI instalments.
  • Interest savings: Amit will be paying an interest of Rs 27,83,661 instead of the regular interest of Rs 41,24,365. He will therefore be saving Rs 13,40,704 on interest payment.

Note: At the time of a lump sum prepayment, a borrower can choose to reduce either the loan EMI or the loan tenure. In the above example, it is assumed that Amit has opted to keep the EMI constant and reduced the loan tenure.

Benefit of Rs 1,00,000 partial prepayment at the end of each year

Home loan prepayment options: a roundup

In the above sections, we explored the various home loan prepayment options that Amit can use and the benefits he will derive from each. Let us now summarise all four:

Summary of home loan prepayment options

Note: To keep the concept of home loan prepayment easy to understand, the above table assumes no change in the home loan interest rate throughout the loan tenure. However, in real life, most home loans are floating rate loans, where the interest rate are revised with the movement in the market interest rate. So, whenever there is a change in the interest rate, all the subsequent calculations will change as per the changed interest rate.

Related: Smart Ways To Reduce Your Loan Stress

Things to keep in mind while prepaying a home loan 

Do not divert money meant to be invested for your financial goals towards home loan prepayment
Some people may not be able to go for a 5% or 10% annual increment in the EMI every year. But at some stage, specifically with a 10% compounded EMI increment, the EMI may become large enough to manage with the cash flows in hand. At that stage, you may continue with the earlier year EMI for subsequent years.
An individual may also consider increasing the EMI by 5% or 10% simple rate every year rather than compounded rate if compounding is difficult to manage.

Last words

As we saw, one can derive substantial benefits from prepaying their home loan. We have discussed four home loan prepayment options, and you can choose one of these depending on your financial situation. You could even customise these prepayment options to suit your requirement. The idea is to try and pay off your home loan as soon as possible, as this can save you a considerable amount.

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