Think Before You Prepay: When Early Home Loan Settlement Might Hurt Your Finances

Prepaying your home loan is not always the best option. Here are some reasons why it might end up being financially negative. When should you opt to prepay your loans? Understanding with a case study.

Think Before You Prepay: When Early Home Loan Settlement Might Hurt Your Finances

A home loan can be a huge burden for some individuals. It allows you to purchase your dream home. But you might not have a minute of peace until you repay the borrowed amount. So, it’s natural to think about prepayment when you get your hands on a significant amount.

While it can bring you peace, prepayment is not always the smartest thing to do. Investing the surplus funds in a suitable scheme might be a better option. Keep scrolling to understand the pros and cons of prepaying your home loan. 

Opportunity Cost of Prepayment

Paying off your loan sooner means putting money towards your debt. A choice is to use it for investments. If the instrument offers good returns, you will earn more money. Check out the interest rate on the loan. After that, consider the possible returns on your investment. 

Loss of Tax Benefits

Are you making monthly payments for your home loan principal amount? If yes, you can enjoy up to Rs 1.5 lakh tax deductions on your annual income. 

Additionally, tax exemptions are also available on home loan interest payments. The upper limit is Rs 2 lakhs for loans on self-occupied houses. For non-self-occupied homes, there is no limit on available deductions. Note that prepaying your loan in full will forfeit these tax benefits.

Liquidity Concerns

The ultimate purpose of prepayments is to reduce interest. But it can dig a hole in your savings. You will need liquid cash for day-to-day expenses. Moreover, you might need your liquid funds quite unexpectedly. For instance, you might suddenly face a healthcare emergency.    

Prepayment Charges

These penalties can reduce the financial benefits of prepayment. Check loan agreement terms to discover charges associated with clearing debts sooner. You should consider comparing the details of your home loan before taking the step towards prepayment.

Case Study: Advantages of Prepayment

Say you have a home loan of Rs 50 lakh. The tenure is 25 years, and the interest rate is 8%. 

You have made timely payments during the first five years. So, your outstanding balance is Rs 46.14 lakh. 

Now, if you decide to make a prepayment, you can either reduce the tenure or EMI.

You make a payment of Rs 5 lakh to reduce the tenure. It will help you save around Rs 11.81 lakh on interest payments. Your tenure will also come down by 5 years and 5 months. 

Are you unwilling to reduce the tenure? In that case, you can also reduce your EMI to Rs 34,409. So, you will be able to enjoy savings of around Rs 5.04 lakh. 

When to Consider Prepaying Your Home Loan

Scenarios Where Prepayment Might Be Beneficial

• During the early part of your home loan tenure, the interest is high. Prepayment helps reduce the principal amount and lowers the interest in the upcoming months. 
• A risk-averse investor usually chooses fixed deposits and other low-return instruments. In that case, it’s better to use surplus funds for prepayment. 
• The age of the borrower also matters. Anyone nearing retirement should forego their existing debts as fast as possible. 

Importance of Assessing Personal Financial Goals and Risk Tolerance

Before you think about prepayments, you should consider your financial objectives. If you need funds in the near future for something like a wedding or higher education, investing might be a good idea. However, you also need to consider your risk tolerance. 

You won’t benefit much by investing in low-return instruments like FDs. You need to think about stocks or mutual funds, which offer high returns despite the increased risk.  

Making an Informed Decision As Per Individual Circumstances

Both prepayments and investments come with a definite set of advantages and disadvantages. You have to assess your situation before making a decision. Prepayment can be a good idea when you have surplus funds. But if paying off your loan early causes financial difficulties in your day-to-day life, it’s never a smart decision. 

Conclusion

Are you planning to get a home loan or considering a balance transfer? If so, CreditDharma will be at your rescue. Even if you are thinking about prepayments, they will help you calculate the savings and everything else. Choose Creditdharma to simplify processes related to borrowing funds for your dream home.