It may seem difficult to repay your home loan well before its effective term. However, you can do this simply if you plan and use your disposable income carefully. A prepayment is a great tool to close the home loan sooner, save interest and reduce the EMI obligation.
There are two ways to close our home loan early. You can either prepay the entire outstanding amount of the home loan, or repay partially in advance. Full prepayment or foreclosure means full prepayment of the outstanding loan amount. On the other hand, partial prepayment allows part of the outstanding loan amount to be paid one or more times during the life of the loan.
Foreclosure may not be possible for most borrowers, especially during the initial period of the home loan. Therefore, they can use the partial prepayment option. Let’s find out the options for partially prepaying your home loan.
Using excess money to prepay a home loan
When taking out a home loan, the borrower maintains the EMI below its current financial repayment capacity. However, after a few years of borrowing, the borrower’s income may increase due to factors such as salary increases. In such cases, the borrower can use the excess income to prepay the home loan.
The borrower can approach the bank with the relevant income documents and ask to reduce the term of the loan to increase the EMI obligation. This can help you save a significant amount in interest. Another option is to accumulate excess money to create a corpus to periodically prepay home loans. Under loan prepayment, banks offer you the option of reducing the loan repayment term or reducing the EMI, you can choose the best option depending on your income stability and financial comfort.
Use the windfall gain to prepay a home loan
People can get windfall gains in their income through employer bonuses, acquiring wealth through inheritance, etc. If you get such a lump sum, it may be a good idea to use it to prepay your home loan.
“Before using the windfall gain to prepay the loan, you need to analyze whether it is better to prepay the home loan or use the fund to invest. If the return on investment is significantly higher than the interest on the home loan, you can deploy the fund into an investment. However, while comparing the two options, you need to consider factors such as the risk level of such an investment, the tax benefit you get on the interest/principal repayment of the home loan, tax on the return on investment, etc. says Adhil Shetty, CEO, Bankbazaar.com.
For example, suppose you received a windfall win of Rs 5 lakh. The interest on your home loan is 6.5% per annum and at the same time the interest on the bank FD is 7% per annum. Assuming you fall in the 20% tax bracket, the net return on investment would be approx. 5.6% pa which is lower than the interest rate applicable to the mortgage. So you can save more money by repaying the loan early.
Save more to prepay the home loan
If you want to get rid of the obligation to repay the home loan sooner than expected, you need to plan it in advance. “You can start by changing your spending habits and focus on cutting unnecessary spending. Set your savings goal higher than your previous benchmark. When there is an increase in your income, be sure to also increase your savings goal. Once you start saving more and more, you can use that corpus to prepay your home loan and close it well ahead of its due date,” says Shetty.
Repay early when loan interest is low
It makes sense to prepay your home loan when the interest rate is low. On your EMI, a lower amount is dedicated to the interest portion and a higher amount to the reduction of the principal portion of the home loan. This happens when your EMI stays the same despite a change in the interest rate and the term is increased.
Let us understand with the help of an illustration below.
Prepay a home loan when interest is low
Thus, from the table, it is clear that in the first years of the loan, if the interest is high, more money is spent on compensating the interest than when the interest rate applicable to the loan is lower. Thus, “if, in the first few years, if you prepay a loan when the interest rate is low, more of your EMI can gradually be used to reduce the principal part. If you prepay your home loan when the interest rate is low, you will be able to close your home loan faster than when the interest rate is higher,” advises Shetty.
Repaying the home loan early can free you from the EMI obligation much sooner than expected. However, you need to be careful with your cash flow needs and maintain a sufficient emergency fund while working on this option.