Pre-Payment On Your Mind? Consider Pros & Cons
With constant rise in the home loan interest rates, the borrowers who had taken the home loan at a lower rate of interest few years ago are now finding it difficult to stretch their resources further to service their enhanced equated monthly instalments (EMIs). A few alternatives are being evaluated by the borrowers to cope with the rise in the interest rates and one of the options being contemplated is part pre-payment/full repayment of loan.
So, MakaanIQ what are the pros and cons of pre-paying your home loan:
Whenever you want to repay the home loan before completion of your tenure, the lenders normally charge a pre-payment penalty on the amount of loan outstanding. Though percentage of penalty varies from lender to lender but it is normally around two per cent whereas some lenders do not even charge any pre-payment penalty.
As per the circular issued by the National Housing Bank to housing finance companies, these have been advised to refrain from charging any pre-payment penalty in case the borrower is repaying the loan from his/her own resources. But, if you are transferring the loan from one lender to another, the housing finance companies are free to levy pre-payment charges. As banks are governed by the Reserve Bank of India (RBI) and since, RBI has not issued any directive on pre-payment penalty, the banks are free to levy the penalty even though the RBI has expressed its displeasure over the practice of levying this penalty.
In case of home loan, borrowers can also consider part pre-payment of the loan. Lending institutions normally do not charge any penalty if the amount prepaid does not exceed 25 per cent of the amount which was outstanding in the beginning of the year. So, in case you are pre-paying partly within the limit of 25 per cent, you can reduce your EMI burden without having to pay any pre-payment penalty. Ultimately it is terms and conditions of your loan agreement, which is the conclusive document to decide whether your lender can levy the penalty.
Since, you get tax benefits on the interest component, the decision whether to prepay the loan and to what extent, will also depend on the tax benefit you are availing. In case the property is self-occupied and the interest component is more than Rs 1,50,000, any repayment of loan, which does not bring down the interest component below Rs 1,50,000, does not have any tax implication. Thus, there will be no impact on tax outgo. However, decision would be different in case the property is let out as whole of the interest payment is tax deductible. So, if you decide to pre pay or part pay your loan then it is important to evaluate the tax impact due to reduction in interest payment.
Liquidity & contingency requirement
The decision to repay the home loan fully or partly should also be made after considering the requirement of funds in the near future to meet certain financial goals. You also need to provide for any financial contingency requirement. So your decision whether to prepay and how much to prepay should be based on both these considerations because as we know that home loans are available at a relatively cheaper than other loans like personal loans and gold loans which are in the range of 18 per cent to 24 per cent.
Take a long-term view
Interest rates do not move in one direction in the long- run. Typically interest rates have a cycle of five to seven years. During this period they move from top to bottom and again commence the reverse journey. Since home loans have a longer tenure, extending upto 20 years, your entire loan tenure may face at least two or three such interest rate cycles. Therefore, before jumping in favour of any decision, you should have a long-term view and act accordingly.
Alternative investment avenues available
While you evaluate the option of prepayment of the loan, you should also consider the alternative options available for deployment of your surplus funds. In case the return assured on such investments are similar, it is advisable not to prepay the loan. One such alternative avenue available for investment are Bonds issued by Non-Banking Financial Companies (NBFCs) to individual investors for a period of four years. Since these bonds will be listed on the stock exchanges, the same can therefore be converted into cash any time to meet the liquidity and contingency requirement.