Monday, November 2, 2015

How best to reduce the burden of home loan prepayment



If you have a home loan, you may have often thought of repaying it, either in whole or in parts. What's the best way to repay?

We receive a lot of queries from young double-income-no-kids (DINKs) clientele, whose primary and high priority goal is buying that "dream home". On an average, one out of five clients asks such a question. They are usually in the middle of paying a home loan, or have booked an apartment and want to know which is the best method to fund it—through regular equated monthly instalments (EMIs), or only interest payments for underconstruction properties.

What are the tax benefits that they can claim in both options? Whether the vested stocks they receive annually or the bonus they get should be directed to reduce their home loan liability? Which is the best EMI option: fixed or floating? Which option to choose when interest rates are rising or falling, and what is the fine print on "fixed interest rate"? These are just some of the questions that we receive on a regular basis.

Obviously there are many permutations and combinations, and each case is unique and requires individual analysis, calculation and guidance. The idea is to work out the best possible option for loan repayment, to enable the lowest impact of interest rate cost to the client.

Firstly, there are many ways to reduce the burden of a home loan—through prepayment (partial or full), by increasing EMIs, or shifting to another loan.

Some choose to foreclose an existing loan and take another loan with the same bank or another bank. This scenario works best in a falling interest rate regime. Mind you, there are costs associated with this, and every individual's loan would involve weighing the pros and cons based on the client situation at hand.

Some choose to increase their EMIs (from the normal specified for a given rate of interest and tenor) to reduce the principal outgo, reduce the tenor, and thereby, reduce the interest charged by the bank. This choice is possible when other commitments such as child's education are already being saved for or the goal has already been met. Some people prepay from the bonus that they may have received or other windfalls.

Let's assume a client has taken a home loan a few years ago, and has a current outstanding amount of Rs 26,04,262 with a monthly EMI of Rs 36,407 to be repaid to the lender. The current interest rate on this loan is 11.75%, and the remaining tenor is 124 months.

There are four scenarios in which this home loan can be repaid. The aim is to see which option works in the best interest of the client for a speedy closure and lowest cost incidence.

Scenario 1: We are assuming that the client makes no change in her EMI, and continues to make the monthly payment towards her home loan. The total interest to be paid for the remaining tenor of 124 months would be Rs 18,99,000.

Scenario 2: We tweak the interest rate and reduce it to 10.50%, and assume that the client's affordability hasn't changed and she is paying the same EMI of Rs 36,407. Since, the interest rate is reduced, she can close the loan in 113 months, saving a total interest of Rs 3,94,000 over the remaining tenor of the loan.

Scenario 3: We further play with the numbers, and assume that the client will make prepayments towards the home loan from the annual bonus she receives. With the same EMI of Rs 36,407 and assuming that the client and her spouse are able to make annual prepayments of Rs 2,00,000 for a duration of five years, the total interest paid under this scenario will be `10,49,147. And surprisingly, the loan will be completed in just 73 months, versus the original duration of 124 months. The total interest saved in this option, is a substantial `8,49,803.

Scenario 4: Lastly, we worked with the assumption that the client is able to increase her EMI to Rs 42,000 per month (because of her annual pay hike). She will be saving a total interest of `4,76,000 over the remaining tenor of the loan, and by doing this, the loan would completed in 96 months.

The result

After doing these calculations, we finally went back to the drawing board and provided the client with the analysis of our findings under different scenarios.

What we learnt was that maximum amount saved (Rs 8,49,803) through interest was with the annual prepayment option. In this scenario, even the loan tenor came down to 73 months. But this is not a thumb rule. One must analyze factors such as the outstanding loan amount or the bank's prepayment charges asked by banks. Apart from this, some banks also put a limit on the quantum of prepayment allowed in a year. Such clauses must be studied carefully. Then there are the client's other goals to be seen—life insurance, healthcare, retirement planning, or even tax planning.

Therefore, when many of our clients approach us with disposable surplus to invest, it is important to asses all parameters and provide a holistic view to best utilize one's savings.

When the interest rates on home loan are higher than the interest earned on investments, it makes more sense to prepay the home loan, than to invest the same.

Dilshad Billimoria is a certified financial planner and director of Dilzer Consultants Pvt Ltd.