Should you prepay your loan or continue the EMIs at higher interest rates?

Banks pushed up their home loan interest rates after RBI's 50 basis points repo rate hike. To date, there has been a 140 basis points increase in repo rate, thus, causing home loan rates to go up steeply. This means that all existing and new home loan borrowers will now face the brunt of paying higher interest rates on the loans sought. Either the borrowers opt for higher equated monthly instalments (EMIs) or must prepay their loans or seek an extended home loan tenure.

These increased home loan rates would be tough on the existing borrowers while it would massively trim down interest among new home loan borrowers contemplating buying their choice of homes this year. V Swaminathan, executive chairman, Andromeda loans and Apnapaisa says, “With this repo rate hike of 50 bps, we are seeing the highest rates that existed pre-pandemic during 2019. This lending rate calibration by the RBI could signal a downward trend in borrowers looking for home loans, as both new and existing home loan equated monthly instalments (EMIs) are set to go up, ushering in a wait-and-watch attitude among new homebuyers.”

Shelling out more

Higher interest rates translate to higher EMIs, which means that borrowers must either resort to paying more every month or opt for a balance transfer to reduce their interest outgo. Increased interest outgo may cause many borrowers to feel the pinch as they will now have to stretch their finances thin to pay for their dream home. With the current interest rates exceeding the pre-pandemic levels, there are lots of upheavals expected in the borrowers’ minds and finances.

Let’s understand the pros and cons of increased home loan interest rates by using HDFC home loan customers as an example.

The current HDFC home loan rates corresponding to different profiles and amounts are listed below.

All banks including the HDFC bank charge interest within the given slab depending on their customers’ credit scores and other factors. There are interest slab rates mentioned, which means that the bank would decide the rate they would charge from their borrowers depending on myriad factors.

Adhil Shetty, CEO, BankBazaar.com says, “Various factors determine the final rate of interest you are offered by the lender. The credit score and history are the important ones. Lenders have internal benchmarks to determine the credit risk component of the loan. The better your score, the lower will be your credit risk, and hence, the cost of your loan. Other parameters that influence the interest rate that you are offered include the loan ticket size, the duration of the loan, and the margin amount. Loans of less than Rs.30 lakh are usually priced lower than the bigger loans."

“Similarly, your loan may be priced cheaper if your loan-to-value is low, say 40-50 per cent, than if it were at 80-85 per cent. The cost of the loan can also vary depending on the location of the property and the job profile of the borrower. Individuals who have a stable income source are considered low-risk, and this shows in the interest you are charged. Similarly, homes which are in a locality with good amenities and connectivity have higher resale value, and are usually priced cheaper,” he added. 

The following table details how the monthly interest outgo would differ over different loan amounts at differing interest rates over different loan tenures for any HDFC home loan customer.

Table 1: Home loans of various amounts at new interest rates

Now compare this to the earlier home loan rates announced by HDFC in September 2021. Following the queue of the country’s top banks and lending institutions pulling down their interest rates, HDFC had announced a slash in their home loan interest rates to 6.70 per cent in September 2021. Apart, the offer of reduced interest rates applied to all new customers irrespective of the loan amount and the nature of their employment.

Table 2: Home loans of various amounts at interest rates as on September 2021

The effect of the increased EMIs is palpable for all kinds of loan amounts. The total interest outgo in Table 2 would be way more than in Table 1.

Seeking an extended loan tenure

Those who cannot extend their finances to repay the higher interest on loans can request the bank to extend the loan tenure. However, they must know that the total amount they would be repaid over the period would be more for an extended loan tenure spread over 25 to 30 years than repaying it within the stipulated period, say in 10-20 years’ time frame.

How does loan prepayment help?

Debt is the biggest liability and reeling under debt is equivalent to suffering from a prolonged financial burden. That’s why it serves best to prepay some amount of the loan to reduce the effect of its burden. For example, a ₹75 lakh loan taken for 30 years at 30 per cent will require you to pay a monthly home loan EMI of ₹55,032. The total interest outgo would be ₹1,23,11,644 and repayment of the total loan amount would amount to ₹1,98,11,644.

Now consider the option that you get the opportunity to prepay the loan amount. Take, for example, you had sought a ₹30 lakh loan at 8 per cent interest for 30 years. Post two years of regular repayment, you earn a windfall of ₹5 lakh through bonuses or business profits. You decide to prepay a part of the loan by putting in ₹5 lakh after two years. You can always prepay a part of the loan, however, small it may seem compared to the original loan taken. However, for this, you must have a lump sum idle amount that may not be equivalent to the remaining principal amount but is enough to relieve you of some burden of the debt sought.

Prepaying this amount saves you ₹32,08,146 in interest and allows you to repay the entire loan amount 67 months before the due date. This way, you have ₹74,79,668 at the end of the fourth year that must be repaid. Again, assume that after 40 years post last prepayment, the business you were into yielded you ₹10 lakh earnings that you would like to use to prepay the article. Prepaying ₹10 lakh of the total amount due would save you ₹31,99,451 interest and reduce your loan tenure by another 72 months, i.e., six years.

When and how to prepay your loan?

There is a direct correlation between the amount you prepay and the time when you do it from your savings account. Prepaying a part of your loan relatively early during the loan tenure saves you a lot on the interest front by minimizing the interest outgo. Usually, banks do not allow their customers to start prepaying their loans during the first year of loan repayment. This means that you may have to wait for at least a year after which you may repay the outstanding amount in part or entirety.

When you prepay a part of your loan, ensure that you are putting in quite a good amount. Prepaying in small amounts does not do much good, especially, when your bank may also levy prepayment charges, thus, negating the effectiveness of prepaying the loan amount.

As opposed to the myth that you can prepay the loan only once, you can prepay a part of your loan amount many times. This means that instead of collecting your earnings and collating your savings at any place to prepay only once, you can prepay a part of your loan every time you gain from your job or business. Many people utilize their earnings from selling stocks at high prices or profits from the business to seek respite from the liability of the loan.

Why prepay your loan?

The increased interest rates have increased the apprehensions of many debtors regarding loan repayment. Inability to repay the loan in time or seeking an extension of your loan tenure may take a direct hit on your credit score, thus, affecting your chances of seeking more loans in the future.

Suresh Sadagopan, founder, Ladder7 Financial Advisories says, “One off delayed payment of fewer than 30 days may not affect your credit score; however, if that happens often it will affect the score. Payment delays beyond 30 days are certain to affect the credit score adversely.”

Though loan prepayment may not affect your credit score immediately, it helps you in effectively closing the loan on time or before time, thus, shoring up your credit rating.

There is an old saying, “Borrow as little as possible, and repay as early as possible”. Unfortunately, many millennials living in an era where everything is available on credit fail to realize how each liability impedes their financial goals and lessens their chances of creating their much-desired corpus in the long run.