Teaser rates are passé. It's the turn of prepayment penalty to take the centre stage. Though prompted by regulatory persuasion and directives, some leading banks are using the abolition of prepayment charges to entice home loan borrowers.
Last week, State Bank of India waived off prepayment charges for all customers — new or old, fixed or floating — and irrespective of whether they are paying from their pockets or switching to another lender. Almost immediately,ICICI Bank, too, removed prepayment charges for floating rate loans.
The National Housing Bank, taking a cue from Banking Ombudsmen's recommendations, had barred housing finance companies from charging a pre-payment penalty to floating rate borrowers, even in case of loan transfers to other lending institutions....
The logic for doing away with the penalty is simple. Since the borrower bears the burden of risk in interest rate movements in case of a floating rate loan, there is no reason why the bank should charge a pre-payment fee. For long, borrowers have complained that banks are slow in passing on the benefits of softening interest rates to existing borrowers, while luring new borrowers with much lower rates at the same time.
Despite the discriminatory practice, old borrowers were hesitant to transfer their loans to other institutions for fear of shelling out a huge amount as pre-payment charge. Until now, banks and HFCs have extended the concession only to borrowers who prepay from their own pockets. Borrowers with little funds of their own are, thus, forced to stick with their bank despite other lenders promising lower interest rates.
Now that pre-payment penalty has become extinct, many could be tempted to exercise this option of switching to a cheaper lender. However, there are certain factors you need to keep in mind before deciding on prepaying/switching your loan.
GET THE TIMING RIGHT
With the barrier for making the switch to another lender having been nearly eliminated, the most pertinent question perhaps in the current context is when to prepay the home loan. For loans being prepaid with own funds, most banks and HFCs already follow the practice of waiving the penalty for fixed as well as floating rate loan borrowers.
Things have never been better for those looking to pre-pay, particularly, if you have just started repaying your home loan. "It is advisable to repay as much as possible during the first five years. For, the interest component in your EMIs is huge in the initial years, while the principal element is miniscule," reasons Vipul Patel, director, Home Loan Advisors, an independent mortgage consultancy firm.
Thus, you will be saving on considerable interest outgo, if you can focus on directing your savings towards prepaying a significant part of the loan during the first five years.
Most home loan borrowers in India strive to pay off their entire loan in 5-7 years, despite the tenure ranging from15-25 years. The reason? They want to call their dream home completely their own as soon as possible and, hence, the hurry to get rid of the debt. And it makes enormous sense, too, as explained above.
However, you also need to factor in the tax benefits that accrue to borrowers repaying their home loan. Under section 80C, you can claim deduction on principal amount repaid, to the extent of Rs 1 lakh, which is the overall cap. The interest amount paid also entitles you to a deduction up to Rs 1.5 lakh, under section 24.If the couples take the loan jointly , then the limit increases to Rs 1.5 X 2 = Rs 3 lakh.
"Given the quantum of tax breaks available, it would be wise to carry out a cost-benefit analysis before deciding on pre-payment. This holds true particularly for those under the age of 35. Others, though, should look at clearing all their debts at the earliest, so that they are in a better position to plan their retirement by the time they 45 or 50," advises VN Kulkarni, chief counsellor with Bank of India-backed Abhay Credit Counselling Centre.
STRETCH EMIS, NOT THE TENURE
Then, there are those who may not be able to prepay large chunks of the loan during the initial years. "Such borrowers can consider increasing the monthly installment to the extent their affordability permits," suggests Patel of Home Loan Advisors. Typically, when the interest rates go up, it's not the EMI amount but the loan tenure that sees an expansion.
This makes the overall interest load heavier for the borrower. "To minimise the burden, you can look at increasing the EMI by 15-20%. Even a 1 percentage point increase in the interest rate can lengthen your loan tenure substantially.
How to Calculate Interest Charged on the Principal of a Loan ?
Understand the idea of compound interest. Since most loans require monthly payments, lenders charge interest monthly, not once a year. This means that you pay one-twelfth of the annual interest rate each month. If your loan has an interest rate of 12 percent, you pay 1 percent per month on the outstanding balance, or principal.
Calculate the monthly payment on your loan. Using a financial calculator (available online) or Excel, input the interest rate you expect divided by 12 (for monthly payments), the total number of payments to be made and the purchase price of the house or car. For example, in Excel you would type =PMT(1/12, 360, -100,000). This would calculate the payment of a Rs 100,000 house at 12 percent interest for 30 years (360 months). You show the Rs 100,000 amount as a negative because it is money you owe. The monthly payment in this problem comes to Rs 1200 approx