24 July, 2012

Considerations for prepaying home loans

Having a roof above one’s head is a recurring dream among us. Most don’t find comfort and peace they seek, in a rental home, however good it may actually be. The primary reason cited is that we may be evicted from this home, anytime. That hangs like a Damocles sword over the head and many find this most disconcerting. The second is that the home may lack comprehensive facilities, which the landlord may not provide. Thirdly, there could be restrictions about the property usage, which can be stifling.

All these drive people to conclude that owning a home is the silver bullet to these problems. Since this belief is widespread, there is a huge demand countrywide for homes. With incomes surging & demand for homes robust, property prices have floated up, up and away. In many parts of the country, it has reached stratospheric proportions.

The upshot is that most people who buy properties take huge loans to give shape to their dreams. EMIs are hence an integral part of most people’s lives now. And these EMIs would go on for long – 20 years, on an average.

There is another quirk that afflicts our people. We have a tradition of eschewing loans. Virtually in every indian language there would be a wisecrack espousing the cause of living debt-free. Hence, being debt-free is an article of faith among most, due to which people are not comfortable having loans. They would like to prepay that as soon as feasible.

Should you prepay your home loan or is it advantageous to keep it? If you need to prepay, when and how much should you prepay? Let us discuss these.

The first aspect to consider is the stability of income of the loan taker. If that is in question, servicing an EMI over the years can pose serious problems. Self-employed can find the income varying a great deal – surging at certain points and dwindling at others. Even among those employed, some employments are more stable than others. In such situations, every endeavor should be made to reduce the loan amount, at every possible point, irrespective of the tax-savings or other considerations. Bonus/ Exgratia or any other inflow can be used to retire outstanding loans. This will bring down the exposed loans.

The second situation where it would be suggested to reduce the loan would be, when the home loan EMI as a percentage of take-home pay is beyond 40%. When the amount is higher than this, it exerts a lot of pressure on one’s cashflows, which is not healthy. Bringing the EMI amount to 40% of the take-home income or less is desirable. It is even more necessary if there are other EMIs for vehicle loans, personal loans to consider. If the EMI amount on the home loan comes below this 40% threshold and does not pose cashflow problems, it can be continued subject to effectively low interest rates, which is the next aspect to be considered.
The third aspect to consider is the effective interest rate that one is paying. In case of home loans, the principal portion comes under Sec 80C and the interest portion comes under Sec 24. After accounting for all the benefits, if one were to calculate the net cost of loan and that interest cost is above what one can earn by investments in a fixed income instrument, then pre-paying the loan is desirable. For instance, if the net interest cost amounts to 9.75% and the post-tax returns from any fixed income instrument is at best only 8.2%, then it is preferable to prepay any extra amount one has.  
The fourth aspect to consider is the tenure. If due to interest rate increase, the tenure extends beyond the superannuation age, it is a red flag. It is desirable to bring the tenure down so that a person can pay-off the loans before he retires. It is generally desirable to finish the loan several years prior to retirement, as a safe practice.

Home loan is a comparatively low-cost loan. If one wants to access loans for others, say a vehicle, it may make sense to instead keep the home loan intact instead of prepaying it and use the cash to reduce the loan to be taken for a vehicle. This will reduce the overall costs. For instance, if one wants to buy a Rs.4.5 Lakhs car in 2 years, and one also has a home loan of Rs.25 Lakhs with an effective interest rate of 9.75%, it may be a good idea to not prepay the home loans in the next two years. A better idea would be to invest the amount that could have been used for such pre-payments and reduce the vehicle loan to be taken. Vehicle loans would be between 2-4% more than the home loan rates and they offer no tax breaks for salaried individuals.

After these considerations, one could decide to keep the home loan or part-pay based on the various points discussed. One could also decide to tweak the EMI. One could keep the EMI high, even though prepayment has been done, to bring down the tenure. Or could allow the EMI to come down as the loan exposure amount goes down, if the tenure does not pose a problem.

The main aspect to keep in mind is that one cannot get obsessed with closing the home loan. Proper consideration needs to be given and one needs to act on the merits of the case.

Article by
Suresh Sadagopan, Founder, www.ladder7.co.in   Published in Business Standard on 22/7/2012

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