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Owning a home is a dream of every individual and with cheap home loan options, the dream can surely be realized in no time, provided you have a regular source of income. Once you own a house then comes the real part of paying off the Home Loan EMI which falls due every month and is one of the biggest monthly expense for most people. EMIs typically take away around 30-40% of your take-home salary or income of individuals. Such huge outflow leaves little scope for more investment and financial planning and to avert such a situation, people opt for longer tenure loans. However, not all realize that longer the tenure, the more you pay for interest.
Typically, if you opt for a home loan for a tenure of 20 years, then in 20 years you pay around more than double the amount of loan you took as principal and interest. For example, you took a loan of Rs. 50 lakhs (5 million) @10% for 20 years then by end of 20 years you pay around Rs. 1 crore 115 lakhs (11.5 million) including interest and principal.
Key discussions of this post
- Power of compounding and how it is favorable and unfavorable.
- Ways to reduce the interest burden and pay off the loan sooner than the contracted period.
- How home loan EMI affect your tax liability.
Long Tenure Loans reverses the Power of Compounding
We all know and hear that when we invest for long term the power of compounding plays a significant role in creating wealth. Similarly, the opposite of it is also true, meaning, if you borrow for a longer duration the power of compounding works in just the reverse direction, thereby draining your money significantly. The longer the tenure, the more you shell out in terms of interest.
To understand this in a simple manner let’s take an example that will show the impact of longer tenure. Assuming, a loan of amount Rs. 40 lakhs is availed at an interest rate of 10% per annum and the tenure is considered of different periods for sake of understanding the impact i.e. 10, 15, 20, 25, and 30 years.
The rising line on the graph makes it evident as to the quantum of interest you pay with an increase in the tenure of the loan. More the tenure, higher the interest cost.
The rate of interest has been kept at 10% for all the tenures and hence the higher interest payout does not translate to a higher effective interest rate.
The absolute interest outgo increases with the corresponding increase in loan tenure. The reason behind this is with lower/smaller EMI (in loans of longer tenure), more than 80% of the EMI goes towards interest payment in the initial years. As very little principal is repaid, and the interest is charged on the outstanding principal, hence you keep paying interest on a higher principal.
On the flip side, when the loan tenure is small (and the EMI is higher), your EMI has a higher component of principal amount and hence it gets paid much faster and the interest burden reduced (refer loan with 10 years’ tenure). For instance, for a loan with 30 years’ tenure, there will be repayment of Rs 1.37 lakhs only of the principal amount in the initial 5 years. While, for a loan with 10 years’ tenure, you will repay Rs 15.12 lakhs of the principal amount in the initial 5 years.
The simple mathematics behind this is that the interest is calculated on the outstanding principal amount, hence faster principal repayment leads to lower absolute interest outgo.
The above analysis may tempt you to go for a lower tenure of loan and you should, however, there is a catch. Lower the tenure means the bank has to recover the principal as well as the same rate of interest from you hence a higher EMI is on the cards. Affordability of EMI will be the deciding factor in opting for a loan with lower tenure. Besides, your banker will be the one who would decide the tenure based on your paying capacity and will maintain a healthy ratio of inflow for you to meet your other regular expenses. You should opt for higher EMI only if your monthly outflow permits or you may soon find yourself in a debt trap. The application of prudence is a must here.
The above analysis is helpful for those who are yet to avail of a home loan and hence can decide the viability based on their monthly inflows. Adding a co-borrower (especially spouse) with earning capacity greatly enhances your borrowing as well as paying off capacity.
People having an existing home loan can reduce their Interest burden through various available means.
The simplest means to reduce the interest outgo is to finish off the principal amount as soon as possible. The sooner you do it, the lesser will be the interest burden. Always remember ‘Money saved is money earned’
Question: How to pay off the principal amount faster?
Answer: There are 2 ways to do so. Decrease the interest rate of your loan or repay the principal amount faster.
a) Decrease the interest rate of your loan.
The lower the rate of interest on your loan, the lower is the interest outgo. Even a fraction of rate reduction plays a huge role in saving a good amount of interest. You can get this done by getting your loan refinanced from a bank or financial institution offering a lower rate.
Words of caution: Prefer Government banks or pure banks, try to avoid Non-Banking Financial Companies (NBFC). NBFCs already borrow from banks and hence their asking rate of interest will always be higher than the Government or pure banks as they also need to repay the banks after keeping their margin. NBFCs are faster in processing your loan and are a little less stringent in the documentation but nothing comes for free. Pure bank word is used to differentiate it from NBFCs.
b) Repay the principal amount faster.
Sooner you repay, the lesser is the principal amount on which interest will be charged and consequently lesser is the interest outgo. Pay more than the regular EMI. The additional amount paid will reduce your principal outstanding and reduce your overall interest burden.
Let’s take a cue from the analysis above. Consider a loan of Rs 40 lakhs, tenure 30 years, and an interest rate of 10% p.a. EMI comes out to Rs 35,103 per month. Total interest cost over the 30 years will come out to Rs 86.37 lakhs. Now applying the above-suggested steps let’s check as to how much we can bring down the overall interest burden.
1. Make a lump sum payment every year or 1 extra EMI.
You can plan to pay off every year a fixed or variable amount to reduce the overall interest burden. This prepayment is possible from the annual bonus or incentive or any savings. For sake of easy understanding, we will consider paying off 1 EMI every year.
For instance, for a 30-year loan of Rs 40 lakhs at 10%, EMI comes out to Rs 35,103. Under this case, you will make an additional prepayment of Rs 35,103 per year. Now your loan will be paid off in 256 months (21 years and 4 months) and the total interest cost will come down to Rs 56.99 lakhs. A saving of Rs 29.38 lakhs in interest outgo.
Lump-sum payment each year will also entail huge savings but a standard example is not presentable here.
Words of Caution: Although there are no prepayment charges but referring to the Mortgage agreement is a must before making a lump sum payment. Also, your home branch may not accept the prepayment sum, so confirm the exact branch or place where you can go to make the prepayment. Yes, you read it right, you will have to visit the branch to make the payment, it cannot be paid online like your regular EMI.
2. Increase your EMI by a fixed percentage every year (Assuming 5%)
You can also opt to increase your EMI amount every year by a certain percentage. This increase goes into the principal repayment part as your regular EMI is already fixed. Now this increase can correspond to an increase in your salary. Say for instance, if your salary increases by 8% per annum, you can increase your EMI by 5% per annum. This way, you will be able to pay off the loan in just 163 months (13 years and 7 months). The original tenure was for 30 years and can be paid in less than half the tenure. The total interest cost outgo in this case comes down to Rs 38.49 lakhs.
3. Option to do one-time prepayment every year as well as increasing the EMI by a percentage, simultaneously.
You can also opt for availing both the options as explained above at the same time i.e. increase EMI every year by a percentage and pay an additional/extra EMI every year. Now this will work like magic, and you will be able to repay the loan in just 140 months (11 years and 8 months) and the total interest cost goes down to Rs 39.4 lacs.
4. Get your loan refinanced at a Lower Rate of Interest
It is a common experience that many times the banks (especially NBFCs) do not pass on the rate cuts to the existing borrowers. You mostly have to ask them about rate cut and they charge you a fee for the same. If the tenure of your loan is still long and any other bank is offering you a loan transfer facility at a lower interest rate, then you must get your existing loan transferred to a new bank at a lower rate of interest. You should keep an eye on such offers. A reduction in the interest rate from 10% to 9% will reduce your EMI from Rs 35,103 to Rs 32,185. That transforms into a saving of Rs 2,918 per month. Over 30 years, it will lead to a lower interest outgo by Rs 10.50 lakhs.
You can even opt for this option if, the cash inflow is not permitting lump sum payment or an increase in EMI. However, do take into account the charges involved in switching the loan from one bank to another, such as processing fees, legal fees, etc. before you make the final call.
Tax Benefits under the Income Tax Act
Home loans also carry tax benefits which one must consider while opting for pre-payment. The principal component of the loan can be availed as a deduction under section 80C up to Rs 1.5 lakhs per financial year. The interest component of the loan (self-occupied house) can be availed as deduction over and above the principal component up to Rs 2 lakhs under Section 24. So, if you fall in the highest tax bracket then, do consider this aspect and work out the benefits it can have before going for prepayment.
EMI affordability is the deciding factor. It is evident that lower the tenure, lower the absolute interest outgo, but the EMI will be higher. The cash flow burden will be on the higher end, hence plan as high an EMI that is affordable.
Words of caution: When you opt for floating-rate loans, it becomes important to consider future interest rate increase that eventually leads to an increase in EMI. Always take this into note before picking shorter loan tenure with higher EMI. In hurry to get off the burden of loan and higher interest outgo, picking up higher EMI with short duration may become a burden in the future which seems affordable today.
All the above scenarios have considered a standard rate of 10% p.a. except, for the case when you get your loan refinanced. The absolute interest outgo is changing as you pay off the loan faster. There are no prepayment charges or processing fees for floating-rate interest loans but it is advisable to check the same with your bank before making the payment. In case of fixed interest rate prepayment penalty/charges will be imposed but, such an instrument is rarely availed unless one is sure of the future rate increase.
The above planning can also be applied to other loans like car loans or personal loans, etc. These loans carry a higher interest rate as compared to a home loan. Hence, overall interest saving is likely to be much higher in terms of percentage. Still, the absolute savings in interest might be lower as these loans are fixed interest rate loans and hence prepayment carries a fee/penalty, which sets off the gain of prepayment. Additionally, the tenure of these loans is of much shorter duration hence the absolute interest outgo will always be lower.
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Vinod on October 02, 2020:
Its awesome article regarding loans and their payments, it's really very useful for society, bcos now days every body is on debt and they are paying heavy amount of their hard earning money, it will help them to save their money and time, and especially health.
Sanjay Kumar on September 24, 2020:
very useful information specially for those who are not able to understand about clear loan repayment process, this will really help.thanks for sharing this important information.
Lord Vader on September 24, 2020:
Skimmed through the article..
Very informative and analysis
Chander Prakash on September 24, 2020:
Nice Article. Any amount paid over and above the fixed EMI always reduces the principal component of Loan. Always try to repay maximum over and above fixed EMI, it will help in reducing the loan tenure and also reduces the interest burden.
virendra vyas on September 24, 2020:
the article about loan repayment is en eye opener for me...and about adding 5% to prepayments is a clever trick i never thought of..
Shikha Singhal on September 24, 2020:
Really appreciate the content and effort for making us vigilant.
Ashish Pandey on September 24, 2020:
Great contribution Sir.
Ankit Kumar on September 24, 2020:
Very nice article.very informative.
Ajay Mishra on September 24, 2020:
Nice and discriptive article sure it will help to persons before borrowing the Loan.
Ankit shankar on September 24, 2020:
Very informative and analytical views in understanding the home loan repayment mechanism.
Gaurav on September 24, 2020:
Valuable information in your article will help me in future
Manoj Chaurasia (author) from Noida, India on September 23, 2020:
You are welcome and feels great to know that you will make the best use of the information shared. TC!
Jolly on September 23, 2020:
Thanks for the excellent write-up, will help me in planning to payoff my existing home loan. Yes, it's true that even after paying for 3 years there is hardly any change in outstanding principal amount.