What is Prepayment?
Home loan prepayment can be understood as the early repayment of a home loan by a borrower. This can be done in part or sometimes full repayment. It is done in order to avail lower interest rates by the means of optional refinancing. Also, it is sometimes possible that the borrower secures enough money and can try to make the full payment earlier than expected. But is it better to invest that money somewhere else or is early repayment a better option?
Home loan pre-payment refers to nothing but paying your full or half due earlier than the tenure. Most of the home loans are around 15 to 20 years and considered to be one of the best investments. In case you plan to close this before the schedule then you must inform the bank or the financial institution or organization in writing.
Almost all of the housing finance companies and banks charge a prepayment penalty usually if the loan is paid off before the tenure completes. Some of the banks do not allow this if you manage to establish the funds to put in for the pre-payment. This will involve furnishing of your salary slips or ITR filing along with your bank statement.
Prepayment Penalties on Home Loans
Banks are forbidden from collecting prepayment penalty anymore on floating rates of loan, this is as per the new rules mentioned by Reserve bank of India.
You don’t have to pay anymore penalty. That is a huge leap forward for the home loan borrowers and consumer welfare if your bank still charges you for a pre-payment penalty; you are eligible to lodge a complaint. You can forward it to the Consumer Forum of India and banking Ombudsman.
The Need for Home Loan Prepayment
Home Loan Prepayment is a good idea because it ends up eating a lot of money in the name of interest. It is not good for your own financial health to give away a big chunk of money as a home loan. There is Home Loan tenure for each and every loan that is passed. Eight years is the average Home Loan tenure in India. Borrowers prefer prepayment in order to clear off their debt when they get a big chunk of money either in the form of an annual bonus, money from matured investments or any other form. Prepayment of Home Loan is needed in most cases because it leads to an increase in the overall cost of property. For example, if you take 80% of your property price as Home Loan, you will end up paying much more and it might eventually lead to an approximation of 3% depreciation of your property. But this percentage totally depends on the city and the area where your property is located. Given this scenario, it is always better to repay the loan as soon as possible because in a way your home loan takes away returns from your property to a great extent.
However, there are scenarios where continuing with Home Loan can be beneficial as well. Let us have a look at all the possible scenarios so that it becomes easy for you to decide whether or not should you be going for a prepayment and/or a pre-closure.
When Should You Go for a Home Loan Pre-Payment?
First thing, a customer can save a lot of money on interest by making a pre-payment of their home loan before the tenure. This is obviously the best pro for prepayment of the home loan.
Paying the entire amount early in the loan tenure so you can take the advantage of foregoing less on interest is the trick. Even at a later stage in the tenure, where customer has paid much of the interest,
If he or she has an excess of cash, it is always a good practice to prepay the loan and get some money off your back.
Some banks have penalty rates which range from 3% to 5% if a customer makes up his mind to prepay his or her loan. However, the Reserve Bank of India had announced recently to stop charging a penalty to the customers who decide to prepay and close the loan account, though this only applies if a loan is levied on ‘floating-rate’ basis. As most of the loans are on fixed rate basis, the rule is not applicable.
There are still some private and public sector banks who do not charge an extra penalty to a customer who opts to do so.
In such a case, it is you in the advantage as you’re making use of idle cash by cutting off the extra interest you had to pay if you paid the regular EMI. The idle cash you possess would return you less when kept in a bank or in a fixed deposit elsewhere than you save on prepaying your house loan.
Let’s take an example where, a personal loan of INR 7.5 million is taken, at an interest rate of 9.5%, and the span is 20 years, the monthly EMI is approximately 69,910/. By the end of 8 years, the person would have paid INR 6,711,360 out of which INR 5,205,117 would be just the interest. If the individual decides to prepay the amount, he would have to pay only INR 788,640 which would be the outstanding amount from the principal, hence saving all the interest money.
Let’s take another example where the individual takes a loan of INR 3 million and the term of 8 years and let the interest rate be same. Here an extra interest of INR 1,294,368 adds up. If the person decides to prepay after 60 months, he would need to pay just INR 316,020 to complete the loan, hence saving INR 213,907 as interest on the loan.
That would be a lot of saving extra money on interest.
When Should You not Go for a pre-payment?
In the case where a home loan is not being a burden on your head, it is sometimes beneficial to continue with the regular EMI schedule. This needs to be brought up as there are tax benefits which home loan offers. Section 80C treats the principal component of EMI. Also, the interest component is deducted, which is from your taxable income, under section 24. Annual detection of the tax can cap up to INR 200,000 per year. However, you won’t be able to claim the deduction paid above INR 200,000, if the annual deduction is higher than INR 200,000, it is sensible to prepay the loan, else, you can consider paying the EMI.
Let’s say for example. For a loan of INR 7.5 million, the annual interest at 9.5% would be INR 706,848. Taking account of INR 200,000 deduction, the interest component would become INR 506,848, which would bring the interest from 9.5% to 8.64%.
In another case, suppose of prepaying the whole amount, you invest the money somewhere else, let’s say mutual funds, which will also help you earn returns over years.
Let’s take another example. Where an individual pays current EMI of INR 22,022 , he has 15 years more left on the loan at an interest of 12%, he is approximately paying INR 66,000 additional, that is around INR 5,500 a month and saves INR 900,000 in interest if he pays the entire loan off if he pays 9 years earlier, he would be missing out tax benefits of approx INR 150,000 a year.
Instead of prepaying the loan, if he invests the INR 5,500 MONTHLY in equity for 9 years. Let us assume 15% cash back on equity, in this case, he would be earning approximation of INR 1.25 million.
In such a case, it would be more sensible to invest in equity rather than prepaying the loan as the profit in equity is clearly more than prepaying.
Hence it becomes your job would be to check what is more beneficial for you.
Effect of prepayment on Income Tax
As mentioned you get relieved of a dividend if you continue with the home loan, if you prepay before the tenure of your home loan, you won’t be getting the tax benefits as mentioned above, Section 80c and Section 24 are under action to save you from an amount of taxes.
Dos and Don’ts of Home Loan Prepayment
There are things to keep in mind when you decide to prepay your home loan; it is wise to know, to what to and what not to do.
- Carry all the documents you need.
Make sure you carry everything you need when you decide to prepay which includes every document you needed while you took the loan. It surely involves a govt. recognized ID such as a PAN card, and also your cheque book. These documents are essential when going for a home loan prepayment.
Hence it is very important to have a detailed track of your home loan related transactions.
Always keep a track of your bank statement which reflects your Home Loan EMI. In case of lump sum payments keep a photocopy of the cheque/demand drafts.
Maintain a file for all home related documents than put them in a cover.
- Be wise in Your loan selection
Before you even take the loan, keep in mind all the consequences you might face and whether you will be able to prepay it or will you benefit from it etc. Keep everything into account and do what is right. Knowing the pros and cons prior to taking a loan is the most important step ever.
- Calculate what you can save before you prepay
As you are already aware that being under a loan would provide you tax benefits, you need to know what is profitable – continuing the loan, or prepaying and getting the load off yourself. So calculating what you can save before you prepay is very important.
- Consider other options before you prepay
Sometimes it is advisable to invest the money you would be investing to prepay, somewhere else, such as a mutual fund or a business which might earn you more in the long term. You obviously save the interest money, but you can earn more than the amount you are saving from the interest money by putting it elsewhere. Being smart and making smart and intelligent choices where home loans are concerned is very important if you want to avoid the long-term difficulties and issues.
- Get an acknowledgement
Always remember to collect an acknowledgement letter signed and stamped by a recognized professional, which should be clearly stating that you have paid the x amount and you do not have to pay further interests or principals and the loan is cleared, or whatever the condition might be. Always remember to take care of the smallest and the important points.
- Don’t make a hasty decision
Hasty decisions never did any good for anyone. Making a hasty decision would overlook the cons of prepaying the loan and that could adversely affect you.
- Don’t borrow another loan
It is quite common where you see people getting under a burden of another loan to pay the previous one, this makes you fall under a never ending cycle and web of constant payments and that can spoil your CIBIL score as well.
- Don’t put up all the money to prepay the loan
Putting all the money to prepay the entire amount would add up more to your financial stress, you sure have to take care of other aspects and keep yourself financially healthy, again this focuses on the first “don’ts” which asks you not to make any decision in haste. Sometimes, it is more beneficial to prepay only half or parts of the principal amount than paying everything in one go.
- Avoiding tax benefits
It is very common for people to neglect the tax benefits they are gaining from the loan they possess and it is a very common mistake on their part.
Always calculate what you can save more in and choose the right option. You would be avoiding the attractive rebates and principal components and saving a lot of money by enjoying these tax benefits.
- Paying a penalty
This one is rare, but under RBI, you are not levied of any penalty charges for prepaying an amount for a loan (Reserve Bank of India). Consider reading the terms and conditions thoroughly and carefully before you do that.
- Terms and conditions
Don’t forget to go through and read the terms and conditions applied before you prepay the amount; you should also go through that before you borrow the loan.
Step by Step Guideline for Prepayment
- Inform this decision of yours to your lender.
The first thing you do is inform the bank about what you decided.
You might need to make a written application and then follow a verification procedure.
You will have to make a full and final payment while carrying all your Identification proof, your loan agreement and all kind of documents which were involved in the same, don’t miss any documents from your part. Sometimes a bank might ask you the source from where you managed to pitch money from. So make sure that you carry your bank and salary slips as well.
- The process itself
You should be receiving an acknowledgement of your payment, in the case where you don’t ask for it. That should clearly mention that no principle out stands or there are no balance payments left after the payment.
The acknowledgement should be stamped and signed by the bank authorized personal.
You should receive an NOC (No objection certificate from the bank) which should also state that the lender has no interest in the property henceforth. It should carry your name, home loan account number, address at the beginning as well as the closure of your loan.
- Collect all your documents
After all, this is done. Remember to carry and withdraw back all the required documents which you submitted. In some case, the page of sales deed goes missing, and it can turn out to be a heavy task for you to get replaced. So make sure, before you sign the acknowledgement all your required documents are in order. It is therefore recommended to collect the documents in person rather than asking the bank to send them to you by courier.
- New Encumbrance Certificate from Registrar
Encumbrance Certificate is a document with all the financial transactions related to the property. After the mortgage is cancelled, it should reflect in the EC. You should apply for an EC in the Registrar Office after the bank has provided you a NOC and the entire existing lien on the property have been removed. Just in case, if the loan closure does not reflects in your EC, you should approach the bank or Registrar for further procedure.
Once this is done, the home loan closure is complete.
- Update CIBIL records
As you clear the entire loan and receive the acknowledgement of the same from the bank.
It will be the time for you to update CIBIL records. It would be of immense significance for you as you closed the loan ahead of your time, and it increases your CIBIL score.
You might have to check once or twice from the lender to ensure that they have sent the details from your end. Once, it has been sent, it might take up to 20-30 days so to update their records, and for the same to show up on your CIBIL score.
So you can wait for a month or two, and then pull out your CIBIL report and the score to ensure that the details of the prepaid loan are on your CIBIL report and now your financial health is in good order.
It is somewhat important to improve your CIBIL score, as it is one of the measures to display your credit health.
Advantages of prepayment of a Home Loan
1. Prepayment or preclosure of your home loan saves on the interest expenditure.
2. Reduces the outstanding principal amount
3. Provides financial stability
4. Effects your credit rating