SYNOPSIS

Before prepaying your home loan –

consider your cash needs for goals, emergencies, etc.
compare return from investments versus cost of home loan
repay higher cost loans first
consider the stage of your home loan tenure
consider prepayment charges, if any

Most of us are averse to being debt ridden. A loan (of any type) is a debt that one would typically want to repay at the earliest (preferably prepay i.e. pay before it’s due). However, a home loan should not be considered in the same light as a personal loan, car loan, etc. A home loan offers a number of benefits which may make prepayment unbeneficial.

Prepayment is a facility which allows you to repay your housing loan (in part or full) before the completion of your loan tenure. Usually, customers opt for prepayment when they have surplus funds.

Important factors to be considered before deciding to prepay your housing loan.

Before deciding to prepay your housing loan...

Avoid getting funds-strapped
Consider income from investments
Keep in mind the stage of the loan
Keep in mind loss of tax benefits
Check if you will have to pay prepayment charges

Funding needs

Before considering prepayment of your housing loan, you need to ensure that you have sufficient funds for your financial goals such as marriage, travel abroad, etc. You should avoid being in a situation where you have overextended yourself to prepay your home loan and, as a result, are funds-strapped when you need to meet a financial goal. Moreover, you also need to ensure that you have surplus funds available for medical emergencies, or unforeseen events such as job loss.

Income from investments

The cost of prepayment should also be compared with the returns that can be earned from investments. If you have the opportunity to earn returns which are higher than the home loan interest, then it is better to invest the surplus funds rather than using the same to prepay your home loan.

A home loan is a long duration loan; in order to make an ‘apples-to-apples’ comparison of your home loan cost vis-à-vis a comparable investment, equity investment should be considered. Equity investment is a long term investment where the risk reduces in proportion to the period of investment, i.e. the longer you hold your equity investment, the lower will be the risk.

Over the last 15 years, the BSE Sensex has given annualized returns of about 15%. Considering home loan interest of 9%, indicated below is a comparison of cost of your home loan vis-à-vis returns from equity investing over the long term.

Home loan interest rate	9%
Tax saving (30% of 9%)	2.7%*
Effective rate of interest	6.3%
*Assuming the highest tax bracket; in case of let-out property, full interest amount is allowed as exemption; in case of self-occupied property, the tax exemption on interest is up to Rs. 2 Lakh. Tax saving on principal repayment (available under section 80 C) is not considered in the example; this will further reduce the cost of the home loan

Average annual returns from equity	15%^
Tax	Nil
Post-tax returns from equity investment	15%
*Average annual returns of the BSE Sensex over the last 15 years - www.bseindia.com

In the scenario given above, the return on investment is higher than the effective rate of interest on the housing loan. Therefore, in such a case, investing the surplus funds is more fruitful than prepaying the housing loan.

Stage of the loan

The main benefit of prepayment is the reduction in interest outflow. The interest component in the EMI is highest during the initial stage of the home loan. Therefore, prepayment of loans in the mid-to-late stage may not give you the full benefit of saving on interest. In such cases, it is prudent to invest the surplus funds.

Interest Rate

Housing loans are easier to service – the interest rate on home loans is generally lower than the rate of interest charged on other loans such as personal loan or credit card loan. Therefore, if you want to reduce debt, it is better to prepay high interest-bearing loans on priority basis (as against housing loans which carry a lower rate of interest).

Tax deduction for home loan

You are entitled to claim tax exemption of up to Rs.1.50 lakh per financial year on repayment of principal amount of housing loan. You can also get tax exemption on interest paid on housing loans (full interest amount is allowed as exemption in case of let-out property, whereas in case of self-occupied property, the exemption is up to Rs.2 lakh). Moreover, with the government’s focus on ‘housing for all’, the tax incentives on housing loans may increase over time. On full prepayment of your housing loan, you will no longer enjoy these tax benefits; in case of part prepayments, you will get lower tax benefits.

Prepayment charges

The decision to prepay your home loan should be considered after accounting for the cost of prepayment. While on adjustable rate home loans there are no prepayment charges, on fixed rate home loans, lenders usually charge a penalty of 2 percent of the amount being prepaid through refinance, i.e. when you borrow to prepay your home loan. However, if you use your own funds to prepay your housing loan, no prepayment penalty is levied.

Upshot

As Indians, most of us are conditioned to think that debt is potentially troublesome. While it’s good to reduce debt, high aversion to debt is not always prudent. You can comfortably manage debt if planned smartly. While availing a home loan, you would have considered your repayment capacity; therefore, prepayment may not be essential. If having an outstanding loan is worrisome for you, then instead of prepayment, you can consider getting home loan insurance, which will protect your dependents from repayment obligation in case you meet with an unfortunate eventuality. Always remember, in a haste to prepay your home loan, do not compromise on liquidity. Ensure that you have sufficient funds available for your financial goals and emergency requirements.