When is it wise to repay home loan prematurely?

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Most of the people are concerned about home loan as its interest rate is lower as compared to other loans like personal loan, car loan, gold loan or credit card. However, due to increase in repo rate, the interest rate of home loan is quite high these days. Since May last year, the repo rate has been increased 6 times and it increased from 4 percent to 6.50 percent. In such a situation, the interest rates which were running below 7 percent, are now ruling at between 9 to 10 percent or in some cases even more.

According to the data of Reserve Bank, due to increase in repo rate, the share of cheap loans in bank loans has decreased. In March 2022, the share of loans with interest rate less than 8 percent in the total loans of banks was 53 percent, which came down to 18 percent in June 2023. At the same time, the share of loans with interest rates of 10 percent or above jumped from 10 percent to 34 percent. In such a situation, it is natural that the thought of closing the loan prematurely comes to everyone’s mind.

Prepayment of home loan means repaying the loan ahead of time. There are some ways to do this. First we repay the entire loan in one go.  It is not possible for everyone to pay so much money at once. The other option is part payment or part pre-payment, that is, you can pay a little amount every year. This will reduce the principal amount of the loan and the loan time. Loan will get closed in advance and you will have to pay less interest too.

Whether to prepay the loan or not it depends on your financial situation. Financial planners believe that home loans with higher interest rates and larger amounts can be pre-paid while, those home loans which have low interest rates and are getting full tax benefits can be maintained. Let us understand this with an example.

Suppose Shashank has a home loan of Rs 25 lakh, whose interest rate is 9 percent. In this, Shashank would be paying interest of around Rs 2 lakh in a year. He is taking tax benefits on this interest that is, the effective interest rate will be 7.50 to 8 percent. It will depend on his tax slab. Shashank can earn more than 10-12% return. If he invests this money in equity or equity mutual funds instead of pre-payment.

If the loan amount is big and the EMI is only Rs 1 lakh-1.5 lakh, then you are paying Rs 12 to 18 lakh in a year. Even a tax deduction of Rs 2 lakh will not be of much benefit. If you are not able to earn as much return as the interest you are paying, then you can pre-pay the home loan. This will save lakhs of rupees spent on interest.

The simple point is that if you can earn up to 12% return by investing the loan prepayment money in equity then loan prepayment is not a profitable deal… if you do not want to take the risk and if you invest this money in such a place whose return is less than the interest rate of home loan like FD or savings account, then it is better to make pre-payment.

Now comes the question… with which money should the loan be pre-paid… If you have received any money as bonus, incentive or in any other way, then you can pre-pay the loan with that. Break any investment and make pre-payment of home loan only when you are facing difficulty in paying EMI every month and if you are getting less return from investments compared to the interest rate of the loan. For example, if you are paying the loan at the rate of 8 percent while the return on your investment is 6 percent, then you can pre-pay the loan.

Now you must have understood when is it beneficial to prepay the home loan. Apart from full repayment and part payment, there is another way.  If you want, you can finish the loan early by increasing the EMI amount. Like Shashank, you too should pre-pay the loan only after considering things like your financial condition and financial goals. Loan pre-payment has both advantages and disadvantages. The advantage is that the interest burden is less. One gets relief from debt and the credit score improves whereas the disadvantage is that there may be a shortage of liquidity i.e. money. Also there is no tax exemption on repaying the home loan.