Why Part-Prepayment Is a Good Idea?
A common feature of all loans, including home loans, is that there is a financial commitment to repay the outstanding amount. The repayment components mainly include the principal amount and the interest charges. Late fees or penalties are also added to this mix, but there might not be any in many cases.
Reducing the interest charges can lower your outstanding balance and reduce the interest burdens. Making a part prepayment of home loans can reduce the interest charges to a great extent. However, the actual benefits are highly contingent on the policies of the home loan provider. Read on to learn more about part prepayment of a home loan and its benefits.
What are part prepayments?
Part prepayment of a home loan or any other debt is repaying a significant share of the outstanding loan amount to reduce the interest burden in the long run. Most people opt for part prepayments of loans when they have surplus money. It could come from bonuses, perks, or other business gains.
Regularly indulging in part prepayment of home loans will help you become debt-free in a relatively shorter period. If you have a floating home loan rate, making prepayments will save you from market uncertainties and an increase in the repo rates which may lead to an increase in your rate of interest.
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Evaluating the cost of prepayment
Depending on the policies of your lender and other terms associated with your home loans, the prepayment process can result in some expenses. In most cases, the prepayment charges are in the range of 0.5 to 3% of the outstanding loan amount.
Those who have opted for a floating rate home loan for non-business purposes are spared as there are no prepayment charges in that scenario. In the case of part prepayment of a home loan taken at a fixed rate of interest, the charges are levied on the amount prepaid depending on the lender’s policy.
However, this can vary greatly depending on the terms of your loan. Comparing the interest charged on the amount prepaid with the prepayment cost will help you make the best decision. In most cases, prepayment is a good option and will save you money in the long run.
How much should you prepay?
Most people are often puzzled about the amount they should be pre-paying for their home loans. It is recommended to spend time on this consideration. You must factor in multiple things, including the cost of prepayment, the interest rate on loans, the nature of the home loan interest rate, the surplus amount available, etc.
Sometimes, the lender may have a minimum threshold set for prepayment of home loans. You won’t be able to make part prepayments if the amount is below the threshold figures. Ideally, it should be higher than the EMIs you pay for your home loans. However, some lenders can have a criterion that requires the part prepayment amount to be at least three times the regular EMI.
When to make a part prepayment of home loans?
Part prepayments of a home loan are certainly a good idea. However, there are some crucial things to be mindful of while making these part prepayments. Knowing when to make the part prepayment is the key to overall savings.
- A lower rate of return
In monetary terms, you should factor in the opportunity cost of making a home loan prepayment. How much return would you earn if you chose to invest the same amount in a secure investment? If the rate of return is higher on an alternative investment of the same amount, it makes more sense to put the funds to better use instead of making the prepayment. However, if the rate of return is lower, you should make prepayments and reduce the interest burden.
For example, let’s assume that you would save interest worth INR 2 lakhs on making a partial prepayment, and if the same amount is invested in an FD, it will give you around 1.5 lakhs by the end of tenure. In this case, making partial prepayments will save you a higher amount. Comparing the opportunity cost is a great way to determine whether the prepayment makes sense.
- Limit credit utilization ratio
The credit utilization ratio is an important parameter used by banks and other financial institutions to determine creditworthiness and repayment capacity. It is calculated by dividing the total outstanding credit used by the total credit limit available. For example, if you have a credit card with a maximum limit of INR 1,00,000 and used INR 30,000, the credit utilization ratio will be 30%. Higher EMIs can lead to a higher credit utilization ratio.
When people buy a house, they assume that their income will rise throughout the loan tenure. This assumption allows them to stretch the EMIs on their current income levels. Making part payments to reduce the interest burden on EMIs is a great way to limit the credit utilization ratio. Ideally, this ratio should be less than 40%.
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