Who does not want to buy a big home, but the limitation is high cost of property. Higher is the cost, more will be the home loan EMI (Equated Monthly Installment’s). The problem with EMI is, it’s a recurring expense. No matter what may come, the EMI will be debited from ones account on a fixed date of every month. Its like a BIG-AUTOMATIC-EXPENSE.
Psychologically, the effect of EMI on the payee is not positive. Its intensity becomes even more magnified when EMI is very high. Is there any way one can reduce EMI of home loan? Yes, by making prepayments EMI can be lowered. Prepayment allows the borrower to pay excess amount, in addition to EMI, and reduce the outstanding principal.
Reducing the outstanding principal directly reflects in the interest payment. High loan balance (principal) will incur higher interest. Low loan balance will incur lower interest. By making prepayments one can reduce the loan balance and save lots of money in interest payment.
Person who is making a prepayment has two alternatives, one is to reduce tenure and other is to reduce EMI. Both ways one can save money. But which is better? Generally, financial gurus will advise people to opt for tenure reduction. Even banks as a default offers tenure reduction. Hence as a result, majority of prepayments made in India are for tenure reduction only. But in this article we are going to discuss the opposite of this trend. We will see how prepayment of home loan to ‘reduce EMI’ can be made a better alternative to ‘tenure reduction’.
Who would like to reduce EMI? People who have purchased expensive property generally pays high EMI’s. Generally speaking, if more than 60% of ones monthly salary (take home after all deductions) is spent on EMI, it can be classified as expensive. It is important for people to take necessary action to bring EMI back to normal levels. Prepayment is the available alternative for the borrower to reduce EMI. It is important to note that for people who are paying very high EMI’s, for them the number one priority is EMI reduction. Reduction of tenure by prepayment may save more money, but it will not serve the purpose.
If planned correctly, EMI reduction option may prove to be a better alternative than tenure reduction. But before, lets see few exemplary facts about EMI reduction and tenure reduction.
Why prepayment is different when done for EMI Reduction and when done for Tenure Reduction?
When one prepays home loan, loan outstanding is directly reduced. Lower level of loan will charge less interest. This is clear, but why for the same prepayment value, tenure reduction shows higher savings and EMI reduction shows lower savings? This happens due to lowering of EMI. The higher the EMI the faster the loan outstanding decreases. When loan tenure is longer, calculated EMI is lower. When loan tenure is shorter, calculated EMI is higher. Higher EMI means one pays more principal. Lower EMI means one pays less principal. Lets try to understand this with a small example. Two friends Jack and John has taken Rs 50Lakh loan @ 10% interest. But Jack’s loan tenure is 15 years and John’s loan tenure is 20 years. For Jack, the EMI is 48,251 per month. For John the EMI is 53,730 per month. Lets compare how much interest is paid by Jack and John in the first month.
The table clarifies this very well that why paying higher EMI is advisable. In the first month, both Jack and John is levied the same interest charges (Rs 41,667). But because John is paying higher EMI, the principal adjusted for him, in the first month itself, is higher. As principal amount is reducing faster for John, he will pay lesser interest. Banks in no way will compromise on their interest earning. Lower EMI gets adjusted by paying lesser principal component.
How much savings can be achieved by prepayment (EMI Reduction vs Tenure Reduction)?
For the sake of comparison and clarity lets see a tabulated information. This tables compares savings in ‘EMI Reduction’ & ‘tenure reduction’ for the same prepayment amount. If one makes a prepayment of Rs 60,000 / year (for the total tenure of loan), total savings will be Rs 6,95,431 (in case of EMI Reduction) & Rs 16,81,623 (in case of Tenure Reduction). Similarly, if one makes a prepayment of Rs 180,000 / year (for the total tenure of loan), the savings will be Rs 20,62,574 (in case of EMI Reduction) & Rs 34,21,134 (in case of Tenure Reduction). It is very evident that prepayment for tenure reduction can save more money for the borrower. But there is a way to make EMI reduction equally profitable for the borrower. In fact, I have realized that prepayment (for EMI reduction) can be used as a tool for more controlled & assured wealth creation. Later in this article we will see how this can be achieved.
|Prepayment / Year||EMI (64Lakhs, @9.55%, 20 Years)||EMI Reduction||Tenure Reduction||Savings Difference|
|Total Saving||Reduced Tenure||Total Saving||Reduced Tenure|
How much EMI can be reduced by Prepayment of home loan?
Prepayment of loan directly lowers the principal amount. Keeping the tenure unaltered, lower principal amount directly lowers the EMI (considering the same interest rate). In order to understand how much EMI can be reduced by prepayment, lets see a table. If one makes prepayment of Rs 60,000/year, after 2nd year, EMI will reduce from Rs 59,866 to Rs 58,708. If one makes prepayment of Rs 96,000/year, after 4th year EMI will reduce from Rs 59,866 to Rs 56,068. If one makes prepayment of Rs 156,000/year, after 10th year EMI will reduce from Rs 59,866 to Rs 40,160. This table has been prepared with an assumption that prepayments have started from the first 12th month itself.
Ask a person who has been paying EMI regularly for last few years. Even small reduction of Rs 500 per month can make them super happy. For a person who is paying very high EMI (compared to income), even minor reduction in EMI may provide them respite.
|Prepayment / Year||EMI (64Lakhs, @9.55%, 20 Years)||EMI (After Prepayment)||% Reduction of EMI in 10 Years|
How to make EMI reduction even more profitable?
When one makes a prepayment and reduces the EMI, they are actually reducing their expense. Reduction of expense means the person has extra money in hand (savings). If one can intelligently invests this money, these saved expenses can generate even more money. Lets take an example. Suppose one made two prepayments of Rs 60,000 each in year 1 and year 2. At the end of second year, due to prepayment, EMI gets reduced from Rs 59,866 to Rs 58,708 per month (EMI reduced by Rs 1,158/month). Now instead of spending this savings elsewhere, if one starts a SIP of this value, it will make the savings grow further. SIP of Rs 1,158/month @ 15% returns will amass a wealth of Rs 9,76,784 in 16 years 4 months).
|Lump Sum Prepayment for 2 Consecutive Year||EMI (64Lakhs, @9.55%, 20 Years)||EMI (After Prepayment)||Savings Per Month||SIP Tenure (Equivalent to tenure reduction due to prepayment)||Investment Return (Time Horizon of 20Y)||Wealth Created in 20Years due to SIP||Savings Difference|
|Year 1||Year 2||2nd Yr|
It is essential to make prepayments to save on interest component of loan. But apart from the interest savings, prepayment can also serve another purpose. Prepayment can help to improve present cash-flow of a person by reducing monthly EMI. When prepayment is made for EMI reduction, the benefit gets split into three: (1) reduced EMI, (2) smaller interest savings & (3) marginal tenure reduction. In case of prepayment for tenure reduction the benefit is only two (1) large interest savings & (2) large tenure reduction. If one invests the differential amount (reduced EMI) properly, benefits of prepayment for EMI reduction can further be enhanced.