An important element of any loan is the repayment. Repayment is an obligation that borrowers need to meet to ensure they keep their loan accounts squeaky clean. If not, they run the risk of lowering their credit score which will have a bearing on their future loans. Most lenders will not extend loans to borrowers whose credit score is low. Even if they extend loans the borrowers will have terms that are not favourable to them including higher interest rate, lower tenures and lower loan amounts.
One aspect of repayment is the prepayment factor. Prepayment is the process of repaying the loan amount in full well before the loan tenure. Lenders offer partial prepayment or full prepayment with certain terms and conditions that the borrowers have to meet. While prepayment may be beneficial to borrowers it may not be so for lenders as their plans get affected. In the case of borrowers, prepayment could also be detrimental as they may lose tax benefits.
Importance of Home Loan
A home loan is a long-term commitment and typically runs for anywhere from 15 to 30 years. It has the lowest interest rate because a home loan is a secured loan. A home is a treasured asset with emotional overtones and in Indian circumstances a solid investment that serves generations of families. Thus, borrowers need to carefully evaluate the pros and cons of prepayment before opting one way or the other.
Factors to consider for prepayment
The factors that matter when considering prepayment include
- The point at which the loan tenure stands
- Prepayment charges, if any
- The type of home loan – floating rate or fixed rate
- The movement of interest rates in the future
- The loss of tax benefits, if any
- Prepaying other higher cost loans first
- Any compulsive reason for prepayment
- Availability of surplus funds for prepayment
Factors to consider for non-prepayment
Conversely, there are factors that matter when considering non-prepayment such as
- Continuation of tax benefits
- Non-availability of funds for prepayment
- Disposal of property
- Deployment of surplus funds into other investment avenues rather than prepayment
- Rise in interest rates
Thus, a careful evaluation of the pros and cons of prepayment will go a long way in making the right decision.
Evaluation of prepayment option
The evaluation process should include among other things, the following
- Evaluate the costs of prepayment considering all factors that would affect the home loan – it makes sense to use parameters considered for investment decisions
- Borrowers could consider partial prepayment and decide on either reducing the tenure or the EMI amount
- One major factor to consider is the amount of interest payable on the balance principal amount when making partial prepayment decision – the total outflow on interest payment will reduce substantially
- Most lenders charge up to 2 % of the prepayment amount as prepayment charges when the home loan is under fixed rate option – include this cost when making prepayment decision
- Most lenders limit the amount of prepayment and the number of times a borrower can make repayment during the loan tenure – consider this factor while making prepayment decision
Prepayment is an option that borrowers should exercise only after evaluating all the advantages and disadvantages of doing so. If borrowers make prepayment decisions impulsively just because they have surplus funds, they may be making an inappropriate decision and lose out on the many benefits that a home loan brings to them.