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In the previous post I covered why the tax breaks alone do not make a home loan attractive. In this post, I will cover what considerations you should have when taking a home loan and when does it make sense to pre-pay and how. I always believe in understanding issues from the ground-up so I will not use a calculator for making my point. Once you understand the purport of this post, you will be able to use any of the numerous calculators available online.
Let us first understand the break-up of EMI figure into the two components, principle and interest. For the sake of illustration we will take a 40 lac home loan, with 10 % interest for 15 years. Observe the following through the tenure of the loan:-
- EMI for the loan is 42984 Rs and this will remain constant for all of 180 months.
- Month 1 break-up : Interest 33333 Rs and Principle 9650 Rs
- Month 12 break-up : Interest 32410 Rs and Principle 10573 Rs
- Month 24 break-up : Interest 31303 Rs and Principle 11680 Rs
- Month 60 break-up : Interest 27236 Rs and Principle 15747 Rs
- Month 120 break-up : Interest 17074 Rs and Principle 25909 Rs
The outstanding amount of loan after 60 months is still 32.53 lacs. So in effect you have paid only 7.47 lacs of the actual loan taken, even though you are paying more than 5 lacs on EMI every year. What are the key learning that we can get from the illustration that we just saw? Firstly, long tenure loans will mean that you are paying a lot of interest in a front-loaded manner. This benefits the bank as they get their profits earlier. Secondly, it will not make a great deal of sense to pay off the loan when you are well into the schedule – in this case even if you want to pay off after 5 years, you will end up paying a total of about 58 lacs, out of which 18 lacs is the interest amount.
So, what are the important considerations when you take a home loan in the first place? There are several:-
- Make sure you are having at least 20 % down payment to limit the amount the loan. If you can have more, great !!
- Choose a house that you need today and in the next 8-10 years. If you think too much into the future you will tend to go overboard on the house and therefore on the loan amount.
- Ideally go for a 10 year loan tenure if you can afford the EMI. If not go for 15, but no more than that.
- Ensure that there are no charges or penalties for paying off the loan earlier than scheduled tenure.
Taking a home loan needs to be seen as a necessary evil and therefore we must look to pay it off as soon as we can. The longer we delay it the less effective pre-payment becomes. Why is this so? Simply because, with every passing month you are paying a hefty interest. The moment you pay off some part in addition to the regular EMI, you reduce the outstanding amount and now a greater portion of your EMI is used to pay off the principle amount.
What are the ways you can begin to start paying off your loan faster? Well you can put any surplus amount after EMI and regular investments towards this, any bonus or incentives can be used to pre-pay and when you get salary increments or some other one-time inflow you can use it to reduce your outstanding. The key aspect is to keep doing it regularly from the beginning and not waiting till you accumulate a significant sum of money. I would say any time you have 1-2 lacs available to make a payment do so. Remember even after 5 years you pay only 7.47 lacs of principle through your regular EMI.
Buying a home is an important event in one’s life and it has several beneficial aspects. By following the 3 pronged strategy of buying the right kind of home you can afford, taking the right kind of loan with good terms and being aggressive in paying it off you will ensure that you are on top of things from a financial sense.
In the next post I will discuss my own example of buying an apartment in Chennai and how I dealt with the loan.