The liability of a home loan is usually the biggest for an individual. So, it’s no wonder that people want to pay off their home loans as soon as they can. In times of economic uncertainty, job losses and pay cuts, a home loan EMI weighs even more. At the same time, with interest rates at record lows, you may be planning to take a home loan. In such a situation, too, it is important to know the prepayment rules. The decision to prepay a home loan should be taken only after considering all the pros and cons.
Apart from the mental relief from such a huge liability and the need to pay an amount every month, prepaying a home loan frees up funds that can be invested in other instruments to earn higher returns. When you pre-close your loan, the savings on interest are substantial, especially in the early stages as that is when the interest component is the highest. If you pre-close the loan in later years, the savings may not be significant. Do a cost-benefit analysis before making this decision.
Credit scores help banks assess the creditworthiness of an individual based on spending and payments of loans and credit card dues. A home loan is a secured long-term loan and a measurable parameter for the creditworthiness of the borrower. Pre-closure can result in ‘absence of measurable long-term repayment’. However, many lenders treat home loan prepayment as a positive and see it as an improvement in creditworthiness.
Home loan prepayment should be based on the following factors: cash flow, income security, cost of capital and tax benefits. Repaying a home loan by increasing the EMI is sure to affect your cash flow, so proper planning is a must. Home loan prepayment by individual borrowers does not carry any prepayment penalties when the loan is on a floating rate of interest. But funds diverted to prepay a loan could lead to a shortage during a financial emergency. According to industry insiders, medical expenses were one of the key reasons for defaults among home loan borrowers. The situation was compounded by loss of jobs and regular income.
Therefore, make a budget and ensure that you have a financial cushion for emergencies before deciding to divert money towards EMIs. There should be an emergency fund; ideally with at least six months’ expenses. Any extra income like bonus and incentives could be used towards prepayments. You can also invest in high-yield avenues and use the earnings for part payments.
The principal as well as the interest payout towards a home loan offer considerable tax deduction benefits. You can get deduction up to Rs 1.5 lakh on the principal amount under Section 80C of the Income-tax Act, 1961, while interest payment up to Rs 2 lakh is deductible under Section 24 of the Act. There is an additional tax exemption of Rs 50,000 for first-time home buyers. If you prepay your home loan, you will miss out on the tax savings. The impact is higher in the lower tax brackets.
It’s best to find out the details of prepayment from the lender at the time of borrowing itself, so that you are not in for a nasty surprise later.