The question uppermost in the minds of most home loan borrowers right now is whether they should prepay their home loan. The interest rates on home loans are rising and so are the equated monthly instalments (EMIs). Banks and housing finance companies (HFCs) have raised the interest rates on home loans by up to 200 basis points or 2 percent points in the last six months.
Alternatively, many lenders have kept the EMIs unchanged but extended the loan tenure or the repayment period. As a result, most home loan borrowers have seen a 10-15 percent increase in their loan repayment tenure. This means 12 to 15 months more of EMIs for someone with 10 years of tenure left on their loan term.
Also Read: Five ways to save money on your home loan
This may not matter if you are young or have big-ticket purchases planned in the next few years but it could hurt those waiting to enjoy an EMI-free life as early as possible.
The real crux of the problem is that most market analysts and economists expect a further increase in interest rates in India given no sign of a decline in inflation and a steady depreciation in the value of the rupee against the US dollar. This will force the Reserve Bank of India to hike the policy rate to attract capital and shore up the value of the rupee. This is a kind of open-ended financial risk for a home loan borrower with a big outstanding amount.
A way out of this conundrum is to prepay your home loan and free yourself from the interest rate risk. The decision to prepay a home loan will depend on your financial position and future spending plans.
The spread between 5-year bank fixed deposit and interest on home loans from leading banks and large HFCs has shrunk to as low as 100 basis points or one percent. This was more than compensated by the income tax savings that home loans provided.
Now the spread between long-term bank FDs and interest rate on home loans have widened to 300 basis points, a gap that cannot be filled up by the potential saving in income tax that home loan provides. Given this, you are better off pre-prepaying your home loan rather than accumulating savings in your bank account.
Similarly, the spread between interest on provident fund accounts and home loans has turned negative from being positive till six months ago.
In other words, till a few months ago your long-term savings in an employee provident fund or public provident fund were growing faster than the interest burden on home loans. This made sense to build your retirement fund rather than prepay low-cost home loans. Now the table has turned upside down and the rising interest rate on big home loans can hurt your finances and cash flows.
However, prepaying a home loan is not always feasible especially if the outstanding amount is too big. Besides, it is not advisable to empty all your savings for loan prepayment.
This will free you from the interest rate risk and the amount outstanding will also be manageable. As suggested above you can even dip into your EPF or PPF corpus for loan prepayment given the interest rate differential now.
A friend of mine did the same thing. He dipped into all his possible savings and investments and fully prepaid his home loan a year ago. He didn’t want to live with the constant worry of a rise in EMIs or loan tenure due to a hike in interest rate. He is not regretting his decision even a bit.
A middle-of-the-road strategy is to raise your EMIs to the maximum amount that you can afford. This will cut your loan term and loan outstanding will reduce much faster. Combine it with occasional loan prepayment such as when you earn a big bonus or get once a year big pay-out from your organization. It will greatly cut your outstanding loan and loan tenure.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).