A home loan is quite popular among new home buyers as it helps in moving one step forward to achieve the dream of having your own house in life and fulfilling family needs. According to a survey conducted by Home Credit India, two out of every three people in India are willing to take out a home loan.Home loan requirements grew 76% from Rs 44,907 crore in Q4 of the financial year 2020 to Rs 79,043 crore at the end of March 2021.
Another reason for buying a home loan is to upgrade your lifestyle. The basic assumption that most new home buyers have in their minds is that if anyone is paying Rs 20,000 per month for rented accommodation, then why not take a home loan of Rs 20,00,000 and pay an EMI amount of approx. 15000 (based on the current interest rate of approx. 6.75%) for their own house? With this approach, after a certain period of time, the house will be completely EMI-free and the asset value will appreciate.
Also, there is always the option to make a 25% partial payment on the principal amount if the loan tenure is longer than 6 months. If the borrower wants to pay more than 25%, then there is an additional prepayment charge that needs to be paid, which is 2% of the prepayment amount.
It is always advisable to make a pre-payment or partial payment during the initial years of borrowing a loan, as this practise will save a huge amount of interest. In a hypothetical example, if a borrower took a loan of Rs 50 lac for a tenure of 20 years with a rate of interest of 7.5% and managed to make a prepayment of Rs 5 lac in 5 years, then the borrower would be able to save approx. 9 lac from the total interest amount to be paid to the financial institution from which the loan was taken. As per market experts, one should rent a house rather than buy if the monthly EMI goes beyond 30 to 40% of the in-hand income.
Why EMI shouldn't go beyond 30 to 40% is because all the remaining in-hand income will be used for saving, investment, and meeting ad hoc and regular expenses.
After taking a home loan, the biggest question at the time of pre-payment of the home loan amount is whether to reduce the term of the loan or reduce the total EMI amount per month. Reducing the term or reducing the EMI has different significance or importance. Also, it totally depends upon the borrower's situation or comfort; however, one should always keep in mind the high rate of interest that is being paid throughout the entire tenure of the re-payment cycle. It is always advised to reduce the period or loan tenure by keeping the EMI amount the same or increasing the EMI amount every year, as this approach will really help in pre-paying the remaining amount in a shorter tenure, which ultimately leads to paying a lower interest rate compared to a higher rate of interest if the tenure is longer.
Let's understand the difference in interest portion if a borrower opts for pre-payment either by reducing the monthly EMI amount or opting for tenure reduction. Based on the above example, if a borrower is taking a home loan for Rs 50,00,000 for 20 years with an interest rate of 7.5%, then the total EMI per month will be Rs 40,280. If the borrower continues to pay EMI without making a pre-payment, then in 20 years (240 months), the total amount payable will be Rs 96,67,118, of which Rs 46,67,118 will be the only interest portion.
But there is a catch here! Which is in the form of a pre-payment, and that too without reducing the EMI amount rather than increasing the monthly EMI portion if it is within the borrower's capacity, keeping in mind expenses and savings separately.
But there is a catch here! Which is in the form of a pre-payment, and that too without reducing the EMI amount rather than increasing the monthly EMI portion if it is within the borrower's capacity, keeping in mind expenses and savings separately.
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| EMI Calculator - Interest Vs Principal |
Now borrower decides to do a Pre-payment of Rs 5,00,000 at the end of first 5 years. Below will be difference in Interest rate & tenure compared without Pre-payment.
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| Power Of Pre-Payment |
Based on the above calculation, we can say that borrowers will be able to save approx. 9 lacs from the interest portion as the tenure of the EMI payment is getting reduced to 206 months from 240 months, saving 34 months from the interest portion. The EMI amount remains the same, but tenure gets reduced, which ultimately creates a big difference in total payout without pre-payment.
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| Without Pre-Payment Vs With Pre-Payment |
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| % Change Pre-Payment |
Borrowers can only opt to reduce EMIs if the percentage of debt is high and non-manageable along with the home loan EMI amount. Reducing the EMI amount will definitely provide relief in the short run as in-hand money or capital will be more; however, if there is financial stability, then the borrower should go for reducing the EMI tenure as, in the long run, this approach will save interest and reduce the actual EMI amount. If the borrower thinks from a long-term perspective, at a younger age it is easy to become debt-free; however, if the EMI amount is getting dragged out until retirement age, then there is always a possibility of additional burden.
In simple words, based on the above example, if the borrower opts to reduce EMI, it will not save more money compared to reducing EMI tenure. Less EMI with the same loan tenure period of 240 months will make less impact or savings compared to the same EMI with less tenure.
Another example showing the difference in interest rate is when a borrower bought a home loan of Rs 50,00,000 for 20 years (240 months) with an interest rate of 6.75%. The borrower decides to make a prepayment of Rs 5,00,000 in the first year of the loan repayment cycle.
Now it's very clear that reducing tenure rather than EMI will be the best option for the borrower. Based on the above example, one can save approximately double the interest rate compared to opting for EMI reduction per month. So if the borrower wishes to do a pre-payment of Rs 5,00,000 in the initial year by opting for tenure reduction, then the total interest amount can be saved by approx. 10 lacs along with tenure reduction from 240 to 214 months, and similarly, if the borrower opts for EMI reduction as an option, then they can save approx. 5 lacs and EMI reduction to Rs 38,018 from Rs 40,280 on a monthly basis, but tenure will remain the same as 240 months.
"Debt is like any other trap, easy enough to get into, but hard enough to get out of."