Timely payment of EMIs is the second-best way to get out of debt. The best way to get out of debt is by making timely pre-payments.
Your EMI constitutes of the principal as well as reducing interest. However, pre-payments are adjusted only against the principal, helping you make faster progress with your repayment.
Why Pre-Payments?
Pre-payment is especially useful with long-term debt such as home loans where the interest often exceeds the amount borrowed. For example, if you took a loan of Rs. 50 lakh to be pre-paid over 20 years at an interest rate of 8.5%, your interest would be Rs. 54.13 lakh. You borrowed Rs. 50 lakh but repaid Rs. 1.04 crore. For most people, this is a lot of money. In the home-buying process, often the costliest item is the loan itself. In a long-term loan stretching over 20-30 years, the value of interest is often larger than the price of the property itself. And hence, actively pre-paying on your dues can help you clear your loan faster, thus freeing up your disposable income and ensuring major long-term savings.
How Pre-Payment Helps Cut Down Interest
Before we get to the 5% Method, let’s understand the value of pre-payment through a simple example. Assume you’ve borrowed Rs. 50 lakh at 8.50% for 20 years. Your EMI is Rs. 43,391. Your interest over 240 months is going to be Rs. 54.13 lakh. Let’s say you decided to pay one extra EMI over and above every 12th EMI. You rounded off this extra EMI to Rs. 45,000. This would lead to a total pre-payment of Rs. 7.2 lakh, but it would achieve two things. One – your loan will be paid off in the 199th month. Two – your interest falls to Rs. 43.54 lakh, saving you Rs. 10.59 lakh. However, the 40 EMIs you don’t have to pay now would save you Rs. 17.35 lakh. These savings are significant.
The 5% Pre-Payment Plan
I’m using the 5% pre-payment plan to pay off my home loan faster. What is this method? Simple. Every year, I must pre-pay 5% of the amount borrowed over and above the EMIs I repay regularly. Adding the principal being paid through EMIs, this would result in more than 5% of the loan being paid off each year. This would help me close the loan in around 10 years.
How Loan Tenure Reduces Through 5% Pre-Payment
Assume that a 5% pre-payment happens with every 12th EMI. Here’s a table that compares the math for regular loan repayment versus loan repayment on the 5% plan.
What The 5% Plan Achieves
It halves the loan tenure: The loan is paid off in exactly 10 years instead of 20. This means you wouldn’t have to pay 120 more EMIs worth Rs. 52.06 lakh — which is more than the loan itself.
It saves enormous interest: Since you pre-paid Rs. 22.50 lakh over the first nine years, your interest falls to Rs. 24.37 lakh. This saves you nearly Rs. 30 lakh from the projected interest of Rs. 54.13 lakh at the start of the loan.
Your effective interest also halves: You borrowed Rs. 50 lakh, and repaid Rs. 74.37 lakh. The loan was priced at 8.50%, but because of the pre-payment, your effective interest rate was just around 4% over 10 years.
You make rapid progress in the crucial first half: The first half of the loan tenure is when you pay maximum interest. In the left-side plan without pre-payments, you reach the 50% mark of your loan balance in the 14th year. It means it took you nearly 70% of the tenure to reach the halfway mark in your repayment. But with 5% pre-payment every year, you reach the 50% mark in just the sixth year.
Don’t Forget These While Pre-Paying
Simple interest may apply: Most floating rate home loans will attract a simple interest charge on pre-payment. It would be advisable to make the pre-payment at the start of your EMI cycle in order to minimise this simple interest.
Pre-payment charges: On fixed rate loans of any kind, there will be pre-payment charges applicable, which are typically a percentage of the loan balance left at that point.
Minimum pre-payment may be required: Most lenders insist that you pre-pay at least one EMI’s worth. Some may insist that you pre-pay a minimum of twice your EMI.
Use calculator for benefits: Each case is unique. Therefore, to understand your own loan math, use a good home loan EMI calculator.
In summary, with any long-term or costly debt, you should look to pre-pay whenever possible. Pay off your debt sooner in order to achieve other life goals such as retirement planning or upgrading to your next home.
The writer is Head of Content & PR for BankBazaar.com.