Prepayment - “a toast or a bitter pill”?

Ankush and Neeta, both software engineers working for an IT solutions company, were on top of the world when they bought a new flat in Bangalore some 3 years ago, thanks to the bank which extended home loan to make the couple realise the dream of their life. The loan was available in the range of 8.0 - 9.0% on floating rate.

Ankush had no hesitation in going for the offer and borrowed maximum and also went in for a bigger size flat--more than his family’s requirement. He was comfortably paying the EMIs as per loan terms. However, the shape of things started changing since last year with banks and housing finance companies increasing the floating rate of interest constantly.

Today the home loan rates have become dearer and is inching towards 11%. Ankush has been advised by the bank that his EMI needs to be realigned in tune with the rising interest rates for floating rate option or he may have to extend the tenure. He also received another shock when he saw the home loan account statement where in it showed almost negligible portion as repayment in principal and 80% of the EMI has been appropriated for interest payments.

Prepayment - “a toast or a bitter pill”?

This is due to the fact that there has been consistent rise in floating rates. In real terms, it would mean that the cost of loan would increase and you need to pay more interest. It is estimated that with a rise of 1 per cent interest rate interest for a loan of Rupees 1.00 lakh with tenure of 20 years, you need to pay Rupees 7,000/- as interest cost and adds upto to your EMI. At this juncture Ankush had some serious thoughts of reducing the loan burden by making bulk repayment to reduce the interest and principal.

The predicament of Ankush is not unique. Today every home loan borrower is facing the problem of rising interest rates.

Prepayment of Loan--- is it the only way out?

In simple terms, it would imply that paying more means paying less interest and liquidating the loan. But, in reality it would require a thorough understanding of the terms of the loan, interest calculation methodology and penalties for premature payment or closure of the loan.

This article is an effort to enlighten the scores of home loan borrowers about the implications of prepayment and preclosure of home loans, so that they are conversant with the methodology before opting for prepayment.

Priorities:

You are required to list out the financial obligations first to assign a proper rating for priority. It is a well known fact that every home loan borrower would have indulged in multiple borrowing sources to complete the housing project in which he is interested. Liquidity or liquid surplus source is the most important need for the borrower.

Housing is one activity where one goes for erratic financial options like

• Withdrawals from Savings/Fixed Deposits
• Personal Loans/Overdrafts
• Cash withdrawals from credit card limits
• Loans on gold jewellery
• Sale of Stocks/Shares
• Loans from pledge of stocks/shares
• Hand loans from relatives and friends

You will see that before you start paying EMIs you have drained your resources to the maximum with the above options. Well remember that except your savings and selling of stocks/shares all other options listed above create supplementary loan portfolio along with home loan.

Prepayment---the myth and reality

The Myth It is commonly misunderstood that if you prepay home loans early in the tenure would be beneficial with substantial reduction in principal. It is not really true. A typical home loan repayment schedule will have the following pattern- let us say for the tenure of 15-20 years. In fact, the EMIs for the first 5 years will account for 80-85% on interest adjustments and balance to principal account. So, in the initial years if you prepay the outstandings in

prinicipal amount will not get much altered as such.

The Reality

Sources of prepayment would be from savings, fixed deposits, selling of stocks/shares or even personal loans. You should make a conservative estimate as to how much of savings mooted as above should go for prepayment. This is very important because any prepayment should not result in cash crunch which could affect your normal life.

It should also be borne in mind that once you prepay housing loan it would be difficult to borrow back. If personal loans like overdraft or hand loans are very costly in terms of EMIs or interest rate, it would be wiser to liquidate those borrowings instead of prepaying home loans.

Remember secured loans like the home loans come at low interest rates and also carry income tax benefits –for repayments of prinicipal and also interest. You will tend to lose these tax benefits to the extent of prepayment amount for future loan instalments. It is prudent to work out the home loan interest saved visa-vis the tax benefits accrued or derived.

Advance payment of loans will have two options:

Prepayment- wherein you pay certain lumpsum to the loan account and the account is not closed.

Preclosure- where you foreclose or fully close the loan account before the completion of loan tenure. In either case the banks and housing finance companies(HFC) levy penalties in the form of prepayment charges. At present, prepayment charges range from 1 to 2.5% of the prepaid amount (in case of prepayment) or principal outstanding in case of preclosure.

It is very important to ascertain the rates of penalties for prepayment/preclosure, so that in the eventuality the viability of the prepayment options can be judged properly. Banks/HFCs are not very rigid in applying prepayment charges.

As the option for prepayment would be exercised by borrowers who are very prompt in repayments, it is advised to negotiate for lower rates. Certain banks allow prepayments without any charges and upto a limit say 25% of the outstandings at any time.

Why banks recover prepayment charges?

Banks do not lend out of thin air. For lending every rupee they have to raise deposits at a cost from the depositors in the form of savings accounts or fixed deposits which are needed to be kept for certain tenure. The same deposits are lent to various loan segments like business, industry and housing. If a home loan is prepaid before the tenure of the loan, the bank cannot voluntarily close a fixed deposit account of a depositor before maturity and refund. So, prepayment charges are levied to compensate the interest income loss, where the bank would be left with the money of the prepaid loan account without being lent to another customer.

Secondly, the banks have to meet operational costs of the various loan accounts. Every borrowal account attracts expenses on various heads likelegal charges, technical services like computers, ledgers, recovery cells, agreement costs, safe custody of loan documents and others. All such expenses would have been built into the EMIs to be recovered over the full tenure of the loan. Any prepayment/preclosure would mean substantial overhead costs remain unrecovered. Hence the penalties for prepayment.

How much do you save by prepayment?

The following illustrations give indicative benefits of interest savings on prepayment of housing loans. Examples are worked out for a home loan of Rupees 20.00 lakhs at 8.00% p a for 15 years. A prepayment of Rupees 4.00 lakhs is applied at different stages of the loan. The effective interest savings has been illustrated by keeping EMI constant with the tenure varying in one instance and keeping the tenure constant and varying the EMI in another.

Points to remember

• You should think of prepayment if you have liquid surplus after reserving some money for contingencies.
• Negotiate for reduction/waiver of prepayment penalties.
• Prepayment charges are recovered in cash/through account and will not be charged to the home loan account.
• Personal loans, credit card dues and overdrafts should receive priority for prepayment, as default in these segments at a later date would lead to unsavoury incidents of banks/credit card institutions harassing and adopting harsh recovery measures despite levying heavy penal interest and recovery charges.
• Prepayment/preclosure will affect tax benefits on repayment of principal and interest on home loans.
• While making prepayment in joint home loan accounts it must be ensured that the benefits of income tax are not lost while apportioning principal and interest repayments on prepaid amount to the joint borrowers who are co-owners. Obtain necessary certificate or recordings at the material time while making prepayment.
• If benefits under income tax are fully exhausted by the borrower and there is surplus disposable income accruing on a monthly/quarterly basis, one should not be hesitant in opting for stepping up EMI. The advantage is that you save on interest cost on the loan as well the loan tenure gets reduced on account of stepped up EMIs.