This article gives you the mathematical support regarding the financial and life-stage reasons to consider accelerating loan repayment, from income stability concerns to freeing up funds for retirement or children’s education.
Paying double (or 2.06 times to be exact) the EMI pays off a 15-year home loan in 5 years
Should you do that? Pay off your home loan early?
There are many reasons for paying off a home loan early with reducing income stability being an important one for many in their 40s or even 50s. We have written on this topic before: How to manage a home loan if you are worried about job loss?.
In this article, we explore the options of paying off a home loan quickly, due to reasons like:
We will assume a fixed monthly payment, with a fixed prepayment amount, every month. Mathematically,
Increased EMI = Actual EMI + Prepayment amount
i.e.
Increased EMI = x times ActualEMI where x > 1
If you are looking at paying off a home loan quickly with an increasing i.e. step-up EMI, refer to this: How much time and interest do you save if you pay off your home loan using a step-up EMI?.
Before we get into the details of how the Increased EMI is beneficial, we will recap how a home loan works.
The bank gives a home loan to own the property while you use it until you pay back the loan via EMIs. An Equated Monthly Instalment plan (EMI) is a standard way to pay off a loan by making a fixed payment monthly that includes both interest and principal in the same amount.
EMI = Principal + Interest
In each EMI, the split of the interest and principal changes since the interest is based on the outstanding loan balance at that point and the rest of the EMI is principal. As the chart shows, the interest part drops off with time, and the rest is the principal. The actual numbers in the chart relate to a ₹50 lakhs home loan taken at 8% for 25 years. The EMI is ₹38,591. The down payment amount is ₹12.5 lakhs.
You can test the numbers using this calculator:
As you pay back the loan, your ownership share in the house will increase in the same way. At the point of taking the loan, you own 20% of the house (12.5 out of 62.5, of which 50 is the loan). The bank owns 80%. As the loan is repaid, you own more and more of the house as the principal is paid off. This is the concept of building equity in an asset. Equity is the part of the asset you own after subtracting the part that the bank owns.
Home equity value = Current home value - Outstanding loan balance
Once you build equity in your home, that has additional benefits:
We break down the home loan rate into its major components to see where the fluctuations come from.
Repo linked home loan rate = Repo Rate + Spread + Premium
Repo rate: This rate is decided by the RBI. Home loan rates will move up and down as soon as the RBI revises the repo rate.
The latest repo rate is 6.5%. This rate was last reviewed by the RBI on 08 Feb 2024.
Spread: This is an additional rate on top of the repo rate that essentially captures the profit the bank can make off this loan relative to the deposits it offers to customers. This rate is generally revised every three years but will vary from bank to bank.
Premium: An extra value for some specific customers. For example, SBI adds another 15 bps for non-salaried customers or it will depend on the CIBIL score of the borrower. This value is also revised periodically, like every three years.
Related:
This article explains how overall repo rate changes affect both borrowers and depositors.
Here we have assumed that the loan interest rate is 8.8% which is applicable for loans above ₹1 crore. Lowering the interest rate to say 8.5% does not materially impact the numbers in the table below.
Read the above table as :
etc using the equation
Increased EMI = x times ActualEMI where x > 1
where table gives the values of x for various combinations of home loan tenure left and desired time to pay off the loan.
To understand if you should increase your EMI for your home loan:
It should be kept in mind that if your income is stable, it is sub-optimal to pay off a home loan early since market-linked investments have the potential of giving higher returns over the remaining tenue of the loan: How can you pay the least interest and get the most tax deduction on your home loan?.
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This post titled Pay Off Your Home Loan Faster: How Extra EMI Payments Save Time and Money first appeared on 01 Dec 2024 at https://arthgyaan.com
