Rising Interest Rates: Time To Prepay Your Home Loan?

“Home Loan Interest Rates Increased,” screams a newspaper headline, making consumers wonder whether it will be a good idea to break their investments to prepay loans ahead of time.

Here are a few tips to help you with this rather difficult decision

Tip 1: Before you prepay, keep some money invested in modes that can be liquidated easily for unforeseen contingencies. Remember that once you prepay a home loan, that money cannot be borrowed back easily later on.

Tip 2: If you have any unsecured debt (credit card or personal loan), pay it off at once. No risk-free investment can ever give you a post-tax return that will be higher than the post-tax cost of such a loan. The difference is normally so high that even stiff prepayment penalties, in the region of 3 to 5 per cent will not change the decision.

Tip 3: Secured loans (and especially home loans) are a little more complex because they are low cost and may also have certain tax benefits, driving down their post tax cost. The decision should normally be taken in consultation with your financial consultant. As a rule of the thumb, (not applicable in all cases) however, it will normally make sense even to prepay the home loans as long as the prepayment charges do not exceed 2%. There are 2 big exceptions to this thumb rule.

1. Where the interest rates on home loan are lower than the current ruling rate (for example, where you had entered into a fixed rate contract earlier)

2. If principal repayment of the home loan increases the amount of deduction under section 80C (this will happen if you are not fully utilizing the Rs 1,00,000 limit of deduction under this section through other modes of investment such as life insurance premiums, contribution to provident funds, etc.

Tip 4: Be aware of the prepayment penalties applicable in your case. Often, customers are asked to sign loan documents with no mention of prepayment penalty. Thus, they are not even aware of what the actual prepayment charges are. Most consumers also do not retain a copy of their loan document. Hence, they have no record of their loan agreement at all. Remember to keep a photocopy of all the documents you sign. Banks are obliged to send you a copy of the loan document. If they don’t, you can lodge an official request on the bank’s website. If they still do not provide the documents, you can also complain to the banking ombudsman. (www.rbi.org.in)

Tip 5: Prepayment penalties are not written in stone. Prepayment penalties can be negotiated if you have a good credit history. For a select few consumers, banks may sometimes also waive this penalty. They may be more inclined to ignore or reduce the penalty in situations where interest rates have been climbing after the disbursement of the loan and the loan carries interest lower than the market rates. Competition among banks can also force them to be kinder on their customers.

Tip 6: Save on prepayment charges by making partial pre-payments. Quite a few banks do not charge pre-payment penalty if the loan is prepaid partially. The definition of what constitutes partial pre-payment varies from bank to bank. You can make enough pre-payment to ensure that you still need to pay a few more EMIs (normally 12) to completely clear off the loan. This will ensure savings in pre-payment penalty and at the same time help you to save on high interest costs on a substantial portion of the loan.

Prepayment Myth

Some people think that it may be beneficial to prepay the home loan only early in its tenure and not after it has passed the mid-way mark. This is a complete myth.

You may think that the EMI (Equated Monthly Installments) will, for the remaining part of the repayment period, mainly go towards clearing the principal amount as much of the interest portion has already been paid off. Even though this is true, the effective cost of the loan remains the same. Hence your decision should not change based on how much tenure of the loan has already elapsed.

Why do banks charge a prepayment penalty?

It is a practice adopted by banks across the world to primarily cover two kinds of costs.

1) Banks raise deposits at a cost and so, the funds come at a price. They may not have the right to prepay these deposits/loans back to their lenders and hence, may continue to incur a cost. The prepayment penalty helps the banks in mitigating these costs.

2) Apart from the cost of capital, there are several direct expenses banks have to bear. These include legal, technical services and origination fees. Banks work out agreements assuming such costs can be recovered over the full tenure of the loan. Any prepayment leads to a loss for the bank since it disturbs this calculation process. Levying a prepayment penalty makes up for the loss.

A final word of caution before you prepay: Make sure that you have enough reserves set aside to see you through a rainy day or a sudden crisis that can crop up from nowhere. Or else, you will be forced to repeat the cycle: another loan, another interest rate structure, and yet another saga of prepayment penalties.

In short

• Prepay after you have set aside money for emergencies.
• Priority should be to repay unsecured loans like credit cards and personal loans where interest rates are high.
• Banks may waive off prepayment charges if you negotiate.
• At whatever stage of the loan, it is cheaper to prepay.

Why do banks charge a prepayment penalty?

Prepayment penalty helps banks to mitigate the costs of deposits taken at higher rate which they do not have a right to prepay.

Prepayment penalty also covers for the cost incurred in legal and technical services and origination fees. Banks work out agreements assuming such costs can be recovered over the full tenure of the loan, which prepayment jeopardizes.