Home loan is one of the longest duration loan an borrower takes. The decision to borrow money for your dream home is taken very wisely. So is the repayment. Generally, the home loan it taken for a duration of 20 years, but the borrowers intend to close it sooner.
Prepayment is one of the methods used by the borrowers to close their loan before planned tenure. It is the act of paying off a portion of your loan before the official schedule requires you to do so.
For a , equated monthly instalment (EMI) is split into two parts: One pays the interest, and the other part slowly pays down your actual borrowed amount – the principal amount.
As interest is calculated on your outstanding principal, making a lumpsum directly shrinks that principal base.
Prepayment helps you to save money, but it leads to certain losses to the bank as it doesn’t want to lose that guaranteed future income. Therefore, the cost of prepaying depends entirely on the specific rules attached to your loan agreement.
Let us understand with a case:
Suppose you have taken a home loan of Rs 45,00,000 at 8.5 per cent for 20 years. For the initial years, the EMI that you pay goes to the interest part, and principal amount remains untouched.
In case you want to pay Rs 5,00,000 as prepayment. Then this amount will be reduced from the overall loan amount, and your new amount will be Rs 40,00,000. Now, your EMI and rate will be calculated on this amount.
This in turn leads to a massive saving in the interest that you will pay to the bank.
What is the cost of prepayment?
The cost of prepaying depends entirely on the specific rules attached to your loan agreement.
For the unsecured loans like personal loan or a fixed-rate loan, banks usually charge a prepayment penalty.
For a floating-rate home loan, the central banking regulations usually forbid lenders from charging any part-prepayment or foreclosure penalties.
Some personal and auto loans have a strict lock-in period meaning that you are completely ineligible to make any prepayments for the first six to 12 months.
Notably, the prepayment is an effective tool for the first half of the tenure. In the first half, the EMIs are front-loaded with interest. Prepayment in the second year destroys massive amounts of future interest.