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 has 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:
you can take a top-up loan in case you need money for some other purpose like home improvement, or any other reason
the more you will get to keep if you sell the house
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What happens to a home loan when interest rates go up?
RBI, in line with other central banks, has hiked the Repo rate from 4.00% to 6.50% in quick succession:
08-Feb-2023: RBI hiked the repo rate to 6.50% from 6.25%.
07-Dec-2022: RBI hiked the repo rate to 6.25% from 5.90%.
30-Sep-2022: RBI hiked the repo rate to 5.90% from 5.40%.
05-Aug-2022: RBI hiked the repo rate to 5.40% from 4.90%.
08-Jun-2022: RBI hiked the repo rate to 4.90% from 4.40%.
04-May-2022: RBI hiked the repo rate to 4.40% from 4.00%.
The hike is a part of inflation-taming measures put in place by global central banks. For RBI, the Repo rate is now rising towards the pre-COVID-19 pandemic days when the rate was 5.15%. It was lowered twice in March 2020 (to 4.40%) and then again in May 2020 (to 4.00%) to negate the impact of the economic slowdown caused by the pandemic.
As inflation has been rising as the economy recovered, the repo rate rise was inevitable, and further rate increases are unavoidable. The RBI is planning more rate hikes.
The interest rate on your home loan will typically be a floating rate that will fluctuate with overall interest rates in the economy. Usually, the RBI repo rate movements indicate the direction of interest rates in the economy. At the same time, home loans are tied to the Repo Linked Loan Rate (RLLR) or Marginal Cost of Funds-based Lending Rate (MCLR) as per RBI. As inflation increases, the central bank is expected to increase this year.
As interest rates fluctuate, so will your EMI over time. If rates increase, one of two things happen:
the EMI goes up, keeping the loan tenure constant
the loan tenure goes up, keeping the EMI constant
In both cases, the amount of interest to be paid increases. Many borrowers prefer to prepay their loans to reduce the impact of higher interest. Depending on the time left, prepaying the home loan may or may not make sense.
How much extra interest will be paid depending on the time left?
We will assume a home loan with a current rate of 9% and an outstanding balance of ₹50 lakhs. You can determine the impact on your loan by applying the unitary method. For example, if your due balance is one crore, you need to double the numbers in the table.
The table shows the annual change in EMI due to both decreasing and increasing rates. The base case of no change in EMI is in the centre column of the table.
(click to open in a new tab)
To explain the data, if the interest rate rises by 1% and 10 years are left for your ₹50 lakhs loan balance, you need to pay ₹3 lakh extra interest. If more time is left, more interest is to be paid and vice versa.
Therefore, you should prepay your home loan only when a lot of interest will be paid extra without prepayment. Near the end of the tenure, when the amount of interest component is little, there is little benefit to prepay. You should invest the prepayment amount instead for your goals.
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This post titled Should you prepay your home loan at the beginning or at the end of the tenure? first appeared on 19 Mar 2023 at https://arthgyaan.com
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