I should use the prepayment amount to reduce EMI or tenure?

When I was making my first home loan prepayment, this question struck me unprepared.

Anybody who has made a prepayment of their home loan, must have faced the same question.

Banks compulsorily asks this question to the account holder while receiving the prepayment amount.

The problem is, most of us are not prepared for the answer. As a result, banks reduces the tenure by default.

## Stock Analysis Using Microsoft Excel

Just copy and paste stock data into this worksheet to analyse stocks.

There is no doubt that prepayment amount used for tenure reduction is more profitable.

But this doesn’t make EMI reduction obsolete.

There are lot of advantages in utilising the prepayment amount for EMI eduction.

But to take the right decision, we must first know which is a better option, to reduce EMI or tenure.

The answer to this query is tricky as the solution is situation based. But figuring it out is not difficult either.

This article will tell you how…

I have written a separate blog post on loan tenure reduction and its advantages. So you can read this blog post to know more about tenure reduction.

I would utilise this space to talk more about the benefits of EMI reduction.

## #1. The burden of High EMI

We all dream to buy a big home for self. But the limitation is obvious, high cost of property.

Higher is the cost, more will be the home loan EMI.

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 can be negative.

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 of loan allows the borrower to pay excess amount, in addition to EMI, and reduce the outstanding principal.

Reducing the outstanding principal reflects in ones interest load:

- High loan balance (principal) will incur higher interest load.
- Low loan balance will incur lower interest load.

By making prepayments one can reduce the loan balance (hence EMI), and also money on the interest front.

## #2. Reduce EMI or tenure…

Person who is making a prepayment has two alternatives, one is to reduce EMI and other is to reduce tenure.

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 than ‘tenure reduction’.

Who would like to reduce EMI?

People who have purchased **expensive property** 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.

## #3. Paying higher EMI is better…

Before we dig deeper into the option of EMI reduction, a basic fact about tenure reduction must be known.

There is a clear advantage in paying a high EMI (if one can afford).

Lets try to understand this with a small example.

Two friends Jack and John has taken **Rs.50Lakh** loan **@10% interest**.

- Jack’s loan tenure is 20 years.
- John’s loan tenure is 15 years.
- For Jack, the EMI is 48,251 per month.
- John’s EMI is 53,730 per month.

As John has opted for a shorter loan tenure, lets see how it reflects on his **principal paying power**.

Please note how much interest is paid by Jack and John in the first month.

What does this table tell us?

The table clarifies that, paying a higher EMI is advisable. It helps one to reduce ones principal balance faster.

In the first month, both Jack and John is levied the same interest charges (Rs 41,667).

But because John is paying a higher EMI, the principal adjusted for him, in the first month itself, is higher.

As principal amount is reducing faster for John, his principal balance will reduce faster than Jack’s.

So, the effect of lower EMI payment is, principal amount gets paid-off slowly.

Bank’s in no way will compromise on their interest earning.

Lower EMI gets adjusted by paying lesser principal component.

Conclusion: Paying higher EMI is better.

But still there are conditions where one must reduce EMI over tenure reduction. We will see when…

## #4. Difference between EMI reduction and tenure reduction

What is the difference between utilising the prepayment amount for EMI Reduction and 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.

- Higher EMI means one pays more principal.
- Lower EMI means one pays less principal.

Let the numbers speaks for itself….

##### #4.1 Savings in tenure reduction…

- Loan amount : Rs.50 Lakhs.
- Interest : 8.5% per annum.
- Loan tenure : 20 years.
- EMI : Rs.43,391.
- Prepayment Amount : Rs.100,000.
- Prepayment made in the 13th month.
**Interest Savings: Rs.3,79,012.****EMI Savings : Zero.**

##### #4.2 Savings in EMI reduction…

- Loan amount : Rs.50 Lakhs.
- Interest : 8.5% per annum.
- Loan tenure : 20 years.
- EMI : Rs.43,391 (before prepayment).
- Prepayment Amount : Rs.100,000.
- Prepayment made in the 13th month.
- EMI : Rs.42,506 (after prepayment).
**Savings: Rs.1,01,000 (approx.)**.**EMI Savings : Rs.885 per month (43,391 – 42,506)**.

Conclusion: The savings in “tenure reduction” is substantially more than “EMI reduction”.

## Prepayment Calculator used to Reduce EMI

Prepayment of loan directly lowers the principal amount.

Keeping the tenure unaltered, lower principal amount directly lowers the EMI.

In order to understand how much EMI can be reduced by prepayment, I am providing here an excel sheet.

You can **download it from here…**

**How to use this excel sheet?**

##### Step #1 – Enter loan details like this:

##### Step #2 – Enter prepayment details like this:

Suppose loan prepayment has been made as below:

- In month 13th – Rs.10,000

Lets see how this data entry (related to loan prepayment) is made in this excel sheet:

##### Step #3 – Just note the reduced EMI due to prepayment:

##### Step #4 – Note the saving made due to prepayment:

There are two clear benefits of prepayments here:

- It reduces EMI, &
- It also saves some money in long run.

If you will compare the saving achieved due to “tenure reduction” and “EMI reduction”, the clear winner will be tenure reduction (see the above comparison in #4.1 and #4.2).

But what EMI reduction does is to give immediate relief from the EMI burden.

But there is a way to make EMI reduction as profitable as tenure reduction.

How to do it?

Lets read about it…

## How to make EMI reduction 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).

In order to make EMI reduction more profitable, my suggestion is to “wisely utilise these savings”.

What I mean by wise utilisation?

Simply use the saved amount to invest in a mutual fund SIP.

Consider a small example:

- Loan amount : Rs.50 Lakhs.
- Interest : 8.5% per annum.
- Loan tenure : 20 years.
- EMI : Rs.43,391 (before prepayment).
- Prepayment Amount : Rs.100,000.
- Prepayment made in the 13th month.
- EMI : Rs.42,506 (after prepayment).
**Savings: Rs.1,01,000 (approx.)**.**EMI Savings : Rs.885 per month (43,391 – 42,506)**.

In the above example, after making a prepayment of Rs.1.0Lakhs, EMI was reduced by Rs.885.

This Rs.885 should not be used for any other purpose.

Instead, it shall be used for investment in a equity linked mutual fund through SIP route.

Suppose this amount was put in SIP in a diversified equity fund whose details are as below:

- SIP amount : Rs.885/month
- Investment time : 19 years
- Return of diversified equity fund : 15% per annum.
- Effective Return of SIP : 9.57% per annum.

[Please use my SIP return calculator to calculate effective return of SIP]

When Rs.885/month is invested as detailed above, the amount of money that can be generated in 19 years is this:

**Amount accumulated after 19 years : Rs.11,31,000.**

Isn’t it fantastic?

I am sure you are impressed.

So next time when you think about making a prepayment, consider reducing your EMI.

I am sure you will.

## Conclusion

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 us to improve our present cash-flow. This is done by reducing the monthly EMI.

When prepayment has opted for the EMI reduction, there can be three-fold benefit:

- Reduced EMI,
- Savings on Interest Component.
- Probability to use the saved EMI for investment.

In case the prepayment is made for tenure reduction, though saving on interest component is substantial, but there is no scope of further investing the saved amount.

In our above example, you see the benefit yourself:

## Be the first to comment