Should you prepay your home loan ?
Everybody wants to prepay and get rid of home loans as soon as possible, but it may not always make a sense to prepay your home loan.
To drive our point we need to first find your effective home loan interest rate, for this we assume that you have a Rs 20 Lac home loan with tenure of 20 years(24 months) at an interest rate of 10% .
Home loan principal and interest payment is exempt from income tax with below listed limits.
Section 80C: Principal payment, Stamp duty and registration fee payment upto Rs 1,50,000 /- qualifies for tax deduction.
Section 24C: Interest payment up to Rs 2,00,000 /- qualifies for tax deduction.
Note: Above table indicates interest and principal payed over 20 year period .Tax saving calculation includes surcharge on income tax.
Let us suppose you claim maximum tax exemption of Rs 2,00,000 on interest payment. A individual in 10% tax slab will save Rs 2,71,107 in income tax over the entire 20 year period. Tax saved is almost 10% of total interest on home loan, thus home loan interest rate is reduced by 10% for person in 10% tax bracket.
We assume that you do not claim any tax exemption under 80C on principal payment, as Rs 1,50,000 limit is nowadays easily exhausted from PF contribution, insurance premium payment and other investments.
Thus your effective home loan interest rate is reduced as listed below.
You can calculate your effective home loan interest rate using reduction factor listed above as per your applicable tax slab,
Example : For person in 10% tax slab with 9% interest , effective interest rate = 9 x Reduction Factor
= 9 x 0.9
Please note that the reduction factor holds good only when your annual interest is less than Rs 2,00,000, as above this amount you will not enjoy any tax benefit. If you claim exemption on principal payment, then your effective interest rate will be further reduced.
Now as you know your effective home loan rate, let us find out why it does not make sense always to prepay your home loan
1. First Pay off other high interest loans
First pay off other high interest loans like credit card loan,personal loan and car loan etc.For example it makes more sense to payoff a personal which is charging 14% interest ,rather than prepay a home loan with 9% effective interest rate.
If in future if you are planning to apply for loan for some other expense like car purchase,foreign trip,marriage etc, rather save the money for these expenses then prepaying your home loan.
2.Investment can get better returns
Investment instruments like direct equity and equity mutual can fetch you better returns, then interest paid on home loan. Long term investment in equity (minimum 4-5 years), can fetch you returns in the range of 10-15%.
If you find such equity instruments are risky or returns from your investment post tax are less then your effective home loan interest rate, better prepay your home loan.
3.Better to prepay in early stages of home loan
In home loan, interest on loan is recovered before recovery of principal amount.You can see from graph below that at the start of home loan, interest component of EMI is very high and principal component is very low. As years progress , interest component decreases and principal component rises.
Below graph shows effect on home loan tenure on one time prepayment of Rs 1,00,000 from 1st to 20th year. For example if you make prepayment of Rs 1,00,000 in 1st year then your tenure is reduced to 210 months, but prepayment of Rs 1,00,000 in 5th year will reduce it to 219 months ,13th year to 230 months and so on. You can see gap between actual tenure and revised tenure narrows as you delay prepayment.
So if you prepay home loan in initial years of home loan, then there will appreciable fall in home loan tenure. At later stage you will be prepaying only principal component as most of the interest on loan has been already payed. Thus to save on home loan interest and also on home loan tenure better prepay in early stages of home loan.
In later stages of your home loan better invest your money, rather than prepaying your home loan, even if return on your investment is less then effective home loan interest rate.