Home Loan Repayment Options Written by Gopal Gidwani Monday, 11 January 2010 13:04

Tarun is a young professional working in a MNC. Tarun recently got married and he has bought a new flat. He has taken a home loan of Rs 30 Lakhs for 20 years and is paying an Equated Monthly Installment (EMI) of Rs 26,992. Consequences of Interest Rate Hike Tarun is a worried man nowadays. He has heard of all the talks of a rate hike doing the rounds in the market. If that happens his EMI on the home loan will go up. Consequences of Interest Rate Hike Tarun is a worried man nowadays. He has heard of all the talks of a rate hike doing the rounds in the market. If that happens his EMI on the home loan will go up. Tarun is worried that if interest rates go up too much and too fast it might increase his EMI significantly. If the interest rate on the loan goes up Tarun can increase the EMI and keep the tenure of the loan same OR increase the tenure of the loan beyond 20 years and keep the EMI same. Not many banks will allow extension of the loan beyond 20 years. In that case the bank will have no option but to increase the EMI on the home loan. If the home loan EMI goes up much more significantly than expected it can affect Taruns cash flows. Tarun will have to divert his cash flows reserved for other activities like childrens education and marriage, retirement fund; towards servicing the home loan EMI. Such a situation can have a negative effect on Taruns entire financial planning. Like Tarun, lot of people face this situation when interest rates rise rapidly and they are caught unaware. As they dont anticipate this sudden rise in the EMI; they dont have a backup plan ready to face this type of situation. Home Loan Repayment Options So how can people like Tarun plan the repayment of their home loans so that it gets over before the scheduled time? Banks offer various repayment options apart from the normal regular EMI repayment option. Let us see how the use of different re-payment options will affect Taruns loan tenure and interest savings on the home loan. No of Instalments Saved 0 95

Repayment Options When Original Loan is kept for 20 Years When EMI is increased by 5% every year

Total Interest Paid 3478026 2192086

Interest Savings 0 1285940 (37%)

No of Instalments Loan Gets over in 240 145

When EMI is increased by 10% every year When 10 Lakhs Prepayment is made and EMI is kept constant at 26991.78 When 10 Lakhs Prepayment is made and EMI is reduced to Rs 17911 When EMI is increased for 1st 7 years till EMI reaches 36,172 and then kept constant

1762469

1715556 (49%) 2430245 (70%) 1124811 (32%) 1200537 (34%)

113

127

1047781

113

127

2353215

240

2277489

157

83

Let us take a look at each of the above options available to Tarun to repay the home loan in more detail. 1) Step-Up EMI by 5% Under this repayment option the customer can increase his EMI every year by a certain percentage. An employee expects his salary to increase by an average 10% or so every year. With the increase in salary he will have additional resources at his disposal. He can use this monthly additional cash inflow to increase his EMI every year so that he can clear the loan before the original scheduled date. Tenure Gets Reduced: If Tarun goes on increasing his EMI by 5% compounded every year, then his 20 year (240 payments) home loan will get over in 12 years (145 payments). So number of instalments will get reduced by 95 (240 145). Interest Savings: On the original loan of 20 years Tarun would have paid an total interest of Rs 34,78,026. But if the EMI is increased by 5% compounded every year then the total interest paid on the loan will be Rs 21,92,086.73. This will result in interest savings of Rs 12,85,940.15 (37%) for Tarun. 2) Step-Up EMI by 10% Tenure Gets Reduced: If Tarun goes on increasing his EMI by 10% compounded every year, then his 20 year (240 payments) home loan will get over in the 10th year (113 payments). So number of instalments will get reduced by 127 (240 - 113). Interest Savings: On the original loan of 20 years Tarun would have paid an total interest of Rs 34,78,026. But if the EMI is increased by 10% compounded every year then the total interest paid on the loan will be Rs17,62,469.91. This will result in interest savings of Rs 17,15,556.97 (49%) for Tarun. Please note that here in this case the overall interest paid on the loan will almost get reduced to half of the original interest amount. 3) Partial Prepayment of Principal and Reduced Tenure with Same EMI Banks also offer their customers the facility of partial prepayment of principal. Suppose a home loan borrower receives

a lumpsum bonus from his company or some of his long term investments in insurance or PPF, KVP, NSC or bank fixed deposits has matured. He can use this money to prepay some of the outstanding principal on the home loan. Let us see how this repayment option works in case of Tarun. Let us assume that 6 months after taking the home loan, Tarun has got a lumpsum amount of Rs 10 Lakhs from the maturity of some of his long term investments in life insurance, PPF and NSC. Tenure gets reduced: Tarun uses this amount of Rs 10 Lakhs to pre-pay his outstanding principal at that point of time and keeps the EMI same at Rs 26,991.78. Due to this partial prepayment Taruns loan tenure will come down from the original 20 Years (240 payments) to less than 10 Years (113 payments). Interest Savings: On the original loan of 20 years Tarun would have paid an total interest of Rs 34,78,026. But due to partial pre-payment of Rs 10 Lakhs the loan interest amount will get reduced to Rs 10,47,781.15. So Tarun will save a huge Rs 24,30,245.73 (70%) in interest savings. So it makes sense to go for partial pre-payment of principal as and when the borrower has some extra spare funds available with him. Some banks may charge some penalty for pre payment. But please note that the interest savings in this case is a huge 70%. 4) Partial Prepayment of Principal and Reduced EMI with Same Tenure By making a principal pre-payment of Rs 10 Lakhs Tarun also has the option of keeping the tenure same at 20 Years and reducing the EMI on his loan. In this case after the payment of Rs 10 Lakhs Taruns EMI will get reduced to Rs 17,911.41 from the original EMI amount of Rs 26,991.78. This will result reducing the monthly EMI by Rs 9080.37. Also over the entire tenure of the 20 Loan; Tarun will save Rs 11,24,811.88 (32%) in interest savings. 5) Step-up EMI for Few Initial Years The borrower can increase his EMI by 5% or 10% compounded every year for the initial few years and then later keep it constant. Please bear in mind that if the borrower goes on increasing the EMI by say 10% compounded every year, after few years the EMI may become very large and it may become difficult for the borrower to service such a huge EMI. In this case after increasing the EMI for few years till he is comfortable servicing, he can leave it constant in the latter years. Let us assume that Tarun goes on increasing his EMI for the first 7 years and then keeps it constant. The EMI is increased for the first 7 years by 5% compounded every year. Thereafter from the 8th year onwards the EMI is kept constant at Rs 36,172.5. In such an arrangement Taruns loan gets over in 13 years (157 payments) instead of the original 20 years (240 payments). Also the total interest paid by Tarun gets reduced to Rs 22,77,489.08 instead of Rs 34,78,026.88. So Tarun will save Rs 12,00,537.1 (34%) in interest savings.

6) Partial Pre-payment and Step-Up EMI

Under this type of repayment mode the borrower can make a lumpsum payment towards bringing down the

outstanding principal and also go on increasing the EMI by say 5% compounded every year. This will result in the home loan getting over much earlier than the original schedule of 20 years. Also this will result in substantial savings in the form of interest payments made during the tenure of the loan. Conclusion Let us quickly summarise the different re-payment options for Tarun and how these options will affect the loan tenure and interest savings on the home loan. No of Instalments Reduced 95

Repayment Options

Total Interest Paid

Interest Savings 1285940 (37%) 1715556 (49%) 2430245 (70%) 1124811 (32%) 1200537 (34%)

No of Instalments Loan Gets over in

When EMI is increased by 5% every year When EMI is increased by 10% every year When 10 Lakhs Prepayment is made and EMI is kept constant at 26991.78 When 10 Lakhs Prepayment is made and EMI is reduced to Rs 17911 When EMI is increased for 1st 7 years till EMI reaches 36,172 and then kept constant

2192086.73

145

1762469.91

113

127

1047781.15

113

127

2353215

240

2277489.78

157

83

After seeing the benefits of various home loan re-payment options the customer should keep in mind the below mentioned important points before deciding on the home loan repayment options: When the customer goes for increase in EMI or partial pre-payment or a combination of both, he should make sure that he is not diverting the money reserved for his other important financial goals like childrens education or marriage, retirement corpus. If the money for other goals gets diverted towards home loan repayment the other financial goals will suffer. So the customer should analyse his cash flows carefully and then take a decision accordingly. Also when the customer goes for increase in EMI by say 5% or 10% every year he should make sure that he will be able to service the increased EMI. If the customer stretches himself just to finish the home loan in the earliest possible time he may face cash flow problems. For example if the customer goes for increase in EMI by say 10% compounded every year; then after few initial years the EMI may reach a substantial amount and it may become difficult for the customer to service such a huge EMI.

 Also in case of floating loans the interest rate on the home loan keeps getting revised with the movement in the Bank PLR. So once the interest rate changes all the calculations will change. Also banks may charge a penalty either for pre-payment of principal or increasing the EMI. Customers need to check with their respective banks the penalty percentage or the penalty amount before going for the restructuring of the home loan.