Receiving extra money is always a good thing. There may come a time when you may receive some lump sum amount such as a bonus or incentive payment. You could also come across some family inheritance or make a windfall profit if you are a businessperson. However, your conundrum comes when you need to decide how to spend it.
If you have loans including home loans, you are in two minds whether to use the lump sum amount to prepay your housing loan or other loans or probably put to use elsewhere. “To prepay or not to prepay,” the classic Shakespearian dilemma will bother you.
Well, prepayment is a facility offered by financial institutions like Tata Capital, whereby you as a home loan borrower can prepay your home loan or other loans fully and complete the formalities of discharging your loan obligation to the lender. Lenders can also offer you part prepayment facility.
Intuitively, it makes a lot of sense to use the money to prepay and become debt free. But, is it as simple as that? Let’s find out from the following 7 factors that are before you.
1. Prepayment comes with conditions:
Financial institutions like Tata Capital, imposes some conditions for prepayment which could include charges and the number of times you can make the prepayment. For instance, it charges 2% plus taxes for prepayment on balance transfer.
2. Effect of part prepayment on your loan:
If your lump sum amount is insufficient to foreclose your home loan you could consider making a part prepayment as per conditions. The advantage of part prepayment is to reduce your interest burden. For instance, if your principal outstanding is Rs 15 lakh and you want to part prepay Rs 8 lakh, your lender recasts the housing loan with Rs 7 lakh as the principal to be repaid and charges interest accordingly which would also cause a change in the EMI. In fact, part prepayment could be more advantageous if the prospects of an increase in interest rates in the future are high.
3. Which loan to close first?
If you are a person who has more than one type of loan – education loan, car loan, business loan or personal loan – you should try to use the lump sum amount to pay off the loan with the highest interest rate. Typically, personal loans and business loans, being unsecured loans, carry higher interest rates than secured loans such as car loans and home loans. So, it makes sense to clear off the personal loan first and if anything is left over you could consider part prepayment of your housing loan. You can check Home Loan interest rates on the Tata Capital website.
4. Effect on credit score:
Remember that the banks and financial institutions sends details of your home loan to the credit bureau, which uses the data to prepare a credit score for you. Since repayment history is an important factor for credit score part prepayment augurs well for your credit score. Ensure that this fact reflects in the credit score as sometimes delay in feeding information can be detrimental to you.
5. Alternate use of lump sum amount:
Making investment decisions is tricky and with the myriad possibilities for the investment, you find it difficult to choose. You could take the advice of finance professionals to help you make the decisions. One simple rule of thumb is to consider the possible return of your intended investments. If that return is higher than the interest rate you are paying on your home loan it may be better to invest in that instrument.
6. Tax benefits:
This is another area which may require the help of finance professionals. It works both ways. You could get tax benefits or you could lose tax benefits depending on the way you have structured your housing loan. You need to consult a tax professional and use the inputs to make a proper decision.
Timing is a factor that affects your decision to prepay or not to repay. Another thumb rule is that in the initial part of the loan tenure, a prepayment is a good option. This is because you will pay a much lower interest amount on the reduced principal outstanding after prepayment. This also reduces your EMI. However, if you receive your lump sum amount during the later part of the loan tenure it may be better to use the funds elsewhere and allow the loan repayment to be discharged in the normal tenure. Make sure you check and choose the best EMI option.
There could be other factors besides the seven described above that could affect your decision to prepay or not to prepay. Tata Capital and other housing finance companies create their own conditions in accordance with RBI guidelines in respect to the prepayment. You should consider all of them and consult with finance and tax professionals before you make a decision one way or the other.