Should you prepay your home loan?

Just in case you have surplus funds and are thinking about it, here are some pros and cons you must know…

When Arun and Neeta applied for their home loan, Neeta had remarked that they would try and repay their loan as soon as possible by using whatever surplus they have and Arun had disagreed saying that it was not a good idea to prepay a loan. So who do you agree with: Arun or Neeta?

Is it a prudent choice to use surplus funds to prepay your home loan?

Prepaying your home loan: The negatives

Just like when you take a loan, you as a borrower plan ahead. Similarly, the lenders also plan and work on the assumption that a loan will run for a fixed number of years. Thus if the borrower prepays the loan it upsets the bank’s projections and reduces or stops the stream of interest income. Lenders therefore try and dissuade borrowers from prepaying a loan.

These can be in the form of a prepayment penalty clause (this is now being done by almost all banks) or in the form of very stringent laid down procedure for prepayment.

The interest repaid on a loan is eligible for deduction under Section 24(b) up to Rs 1.5 lakh per annum in case of self occupied house. Relief is also available under Section 80EE to home loan borrowers.

By prepaying the loan you could end up losing these tax benefits and depending on the remaining loan tenure this could be a huge loss if considered in totality.

If you plan to make a partial prepayment and there is no impact on the tax eligibility (the interest and principal that you repay is still above the available limits for tax deduction) then you could consider prepaying a loan after keeping other factors in mind.

Keeping something aside for emergencies is always advisable. With growing income and increasing liabilities the size of the contingency fund should also grow. So keep that in mind; do not prepay a loan at the cost of keeping sufficient funds for emergency with you.

In case of an unforeseen event like loss of income etc, EMIs still have to be paid and having sufficient liquid funds is important.

Home loans are usually less expensive than other loans; so if you have surplus funds explore the option of repaying other expensive loans (if any) provided these loans do not have a very high prepayment cost involved.

Prepaying your home loan: The positives

Before deciding whether or not to use the surplus funds to prepay your home loan compare it with the alternative uses you could put the funds to. One could use the funds for investing in options like fixed deposits, PPF or NSC etc. The returns on such investments are usually in the range of 8.5 per cent to 9 per cent which may attract tax, thus making the actual post tax returns lower.

Compare this with the interest rate you are paying on the home loan which would be anywhere in the range of 10 per cent to 12 per cent.

Thus if by prepaying your home loan you end up saving more than what you could have earned by investing that amount then it makes financial sense to prepay a loan rather than invest the money elsewhere.

However if you are seeking to invest in market linked options and are confident that you can get more returns (then what you are paying) then this option might not be for you.

If the loan that you have is expensive than what the current market trends are and if you are planning to take a fresh loan, then it makes sense to the prepay the existing loan which is expensive. This will help in reducing the overall interest burden.

Again if you have two loans and have some surplus then pay the loan which is at a higher rate to reduce your overall interest cost. Prepaying a home loan also makes sense if you are looking at reducing your debt to income ratio or you are nearing your retirement and want to clear all debt before you retire.

Prepaying a home loan or not is a decision that has to be made after considering the market conditions, your current financial positions, the conditions on which the loan has been taken and also the economic implications of prepayment.

Thus after carefully analysing all these factors decide whether you want to prepay a loan or not. There is no rule which says that the entire surplus must be used to make the loan repayment, one could bifurcate it in the ratio they so desire between investment, keeping it liquid and prepayment.

Illustration: Uttam Ghosh/Rediff.com

The author is a credit expert with 10 years of experience in personal finance and consumer banking industry and another 7 years in credit bureau sector. Rajiv was instrumental in setting up India's first credit bureau, Credit Information Bureau (India) Limited (CIBIL). He has also worked with Citibank, Canara Bank, HDFC Bank, IDBI Bank and Experian in various capacities.