Why prepayment of home loans is better in early years of tenure than later. Explained

Notably, Dev Ashish, founder of Stableinvestor explains that making prepayments is better in the early years of the tenure of a home loan rather than later.

Home loan prepayments simply mean you pay a certain portion of your loan amount earlier than the planned repayment period. Generally, a borrower tends to pre-pay their loan amount upon having surplus funds. The benefits of prepayment are that they tend to lower your EMI burdens or shorten the loan tenure or reduce debt and even help in minimising interest rates.

According to the founder of Stable Investor which is a financial planning and investor advisory firm, if you take a home loan, you will realize that the loan principal gets paid off slowly during the initial years. This is exactly why it is better to make prepayments earlier in tenure than later.

In a thread on his Twitter handler, Dev explained that when you opt for long-tenure loans (like home loans), a significant part during the first few years is only about paying interest. This means that interest is ‘front-loaded’.

He further explained with an example. Let’s suppose, you take a ₹50 lakh home loan at an interest rate of 8% for a period of 25 years. The monthly EMI comes to around ₹38,591. While for the entire tenure of 25 years, the total amount you will end up paying a total interest of around ₹65.8 lakh including interest.

Further, explaining the example with a chart, Dev pointed out that the first 5 years (1-5 years) of regular EMI payments (each month without fail), which is 20% of the loan tenure of 25 years, only 7.7% of the loan is paid off. He said, there are a total of five 5-year periods of this 25-year loan (5 years X 25 years).

In the next five years (6-10 years), only 19.2% of the total loan amount is repaid. This would be a rise of 11.5% in the loan paid off from the first set of five years to the second.

From the data, it can be understood that, by the end of 15 years (the third set of five years which is 11-15 years), around 36.4% of the loan is paid off — which is a rise of 17.2% from the second set. But there is a massive jump of 25.5% from the third set, as by the end of 20 years (fourth set of five years which is 16-20 years) around 61.9% of the loan is paid off.

Compared to the fourth set of tenures (16-20 years), there is a jump of 38.1% as in the fifth and the last set of tenures (21-25 years) — 100% of the loan amount is paid off.

Hence, Dev said, the EARLIER you make the prepayments, the better it is for you in terms of its impact on reducing the total interest paid during the loan tenure. Read his entire thread here!

Also, Nalin Jain, Chief Customer Officer, and Head, of Operations at Godrej Capital said, a home loan is a long-term financial commitment, and often, the interest component exceeds the principal amount due to the long tenures of a typical home loan of 20 to 30 years.

Godrej Capital’s Nalin added that it is best to opt for the home loan prepayment option during the initial tenure of the loan when the interest component is high. He added, opting for prepayment at a later stage may not help maximize the benefit of being debt-free early. Thus, timing plays a crucial role in prepayment.

Similarly, Jairam Sridharan MD of Piramal Capital & Housing Finance highlighted that prepayment of home loans in the initial part of the loan tenure is always a good option. This can help reduce the EMI or pay a much lower interest amount on the reduced principal outstanding after prepayment. If a borrower happens to receive a lump sum amount in the later part of the tenure, then it may be a good idea to invest it elsewhere and repay the home loan in the normal tenure. The borrower may also seek the lender’s help to choose the best EMI option.

It needs to be noted that home loan interest rates have gone up significantly since RBI’s rate hike cycle began in May to tame multi-year high inflation. So far in FY23, the central bank has hiked the repo rate by 225 basis points to 6.25%. The latest hike would be 35 basis points in December 2022 policy.

After the 35 bps rate hike, Shiv Parekh, Founder of hBits said, “The commercial real estate growth is pulling lots of investment, it has been stable through all ups and downs. Even the current repo rate hike will not affect much on commercial real estate much, as the current increase is in line with RBI’s mission to take on inflation. As there has been a moderate hike in the home loan too, the affordability of the home loan is still fine from a residential perspective. We expect that the positive sentiment will remain in the CRE sector. When it comes to fractional ownership, it is one of the best investments at this time which gives steady and stable returns.”

Parekh added, “However, the real estate industry expects a reduction in the key rates going forward, which will be widely celebrated, as lowering interest rates has been a crucial factor in the revival of the demand in overall real estate. It will help in improving the liquidity situation which is vital for the sector.”

Meanwhile, Ramani Sastri – Chairman & MD, Sterling Developers said, the continuous rate hikes may lead to short-term turbulence in the overall housing demand when buyers are optimistic about making a home purchase decision and this may add to buyers’ overall acquisition cost. The real estate sector had started seeing gradual recovery across key property markets, driven primarily by end-users, however, the repeated rate hikes may impact the interest rate-sensitive sector. Low-interest rates have been the biggest factor in the resurgence of real estate demand in the last few years and hence the rate hike would mean a hurdle in affordability.

However, Sastri also added that there is a positive sentiment, as the affordability and disposable incomes of new-age homebuyers are much better than in the past. Despite the odds, we’re still hopeful as there is significant pent-up demand from a very large population base and first-time home buyers. Real estate is definitely among the best instruments to invest in and looking ahead, and the Sterling Developers chief believes that markets will see sustained growth over the next few years.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint.