You take a 20-25 year home loan and then you want to get rid of it as soon as possible. And to do that, you start making regular prepayments. I have written about the best home loan prepayment strategies several times and to be fair, there is nothing wrong with prepayments.
After all, who doesn’t want to be free of the loan burden?
But does it make sense for everyone to try to start prepaying the home loan?
The answer is no.
And this is despite the (mathematical) fact that home loan prepayment helps reduce the interest burden (i.e. total interest paid) substantially and thereby, reducing the actual landed cost of the house.
To give a simple example of how prepayments help reduce cost first will be useful.
Suppose you purchased a Rs 1 crore house. You paid Rs 20 lakh in downpayment and took another Rs 80 lakh home loan for 20 years at 8.5%. The landed cost of your house (ignoring the time value of money for simplicity) is Rs 1.86 Cr (which is Rs 20 lakh downpayment + Rs 80 lakh home loan principal + Rs 86.8 lakh in interest payments over 20 years).
Now suppose you made Rs 2 lakh extra prepayment each year. In this case, the interest paid over the reduced 14-year tenure would be a much lower Rs 51 lakh. So the landed cost of your house is reduced in case of prepayments.
Coming back to why everyone shouldn’t be prepaying home loans aggressively.
People who for different reasons become super-obsessed with prepaying home loans (like trying to clear a 25-year home loan in less than 10 years), forget (or rather ignore) the fact that there are other things in life as well that need money:
- If you use up all your savings in house purchase and then also use up all your monthly surplus to prepay the home loan, then you will have no buffer. And a buffer for what? Financial emergencies. These don’t wait for you to have an emergency fund in place. So, if you don’t have an emergency fund, but want to prepay your home loan, then please don’t commit this mistake. Start saving for your emergency fund, please.
- Also, if you already have an emergency fund in place and are tempted to use it for prepayment, then too the advice is to not do that. Never make the mistake of using the emergency fund to part-prepay home loan. I have a close relative who did exactly this and when he had a sudden large expense, he had to borrow from us family members.
- Once the above aspect is tackled, then again you may be tempted to start prepaying. But hold on. There are other things first.
- Some of your financial goals may not be immediate, like say the higher education goal of your 7-year-old child. The graduation for him/her will begin in 10 years and hence, you may not feel like saving for it and instead tackle home loan prepayments first. But this can be costly in the long term. And that is because, with each month/year you delay saving, you will have to save more money later on due to inflation to fund these goals. Suppose you want to save Rs 50 lakh for higher studies in 10 years’ time. If you start today, then at about 10-12% average returns, you need to invest Rs 22-25,000 monthly. But if you delay say be 5 years, then to reach the same goal, you will need to do Rs 58-60,000 monthly.
- So, for a critical goal like child’s education, delaying saving just because you want to clear home loan first, can derail your goal planning!
- Saving for retirement is another important goal but sadly, it doesn’t get the importance it deserves. Here too, it’s natural to feel like putting it on backburner as its so far off in the future. But like for above goal, even retirement maths works in a similar fashion and the more you delay it, the more you need to save for it when you finally begin.
Now let’s say you earn well and even after considering all the above points, you still have money left. What should you do then?
In this case, you need to first look inward and assess your risk appetite.
If you are a conservative person, then you can start making prepayments. That will keep things simple and you at peace. The other option for more aggressive risk-profiled people is to invest this surplus money elsewhere where you can get better returns than post-tax-benefits home loan rates. This will not only help better optimize your returns but also help you build up a sort of buffer that you can use to make larger prepayments (or even one-shot loan closure) in future if home loan rates rise and become costly.
But as I said, this approach and choosing to invest vs prepaying loan is not for everyone, and only suited for those with higher risk appetite.