Does It Make Sense To Prepay Your Home Loan In a Rising Interest Rate Scenario?

Many home loan borrowers believe that it is always a good idea to prepay a home loan when there is a sharp rise in home loan interest rates. However, that might not be the best option always.

The home loan interest rates are amongst the lowest compared to other types of loans. Besides, there are several tax benefits on the home loan principal amount and interest paid. But the borrowers must understand that these benefits have limitations, and continuing the home loan considering only these benefits might not make sense in many cases.

Let us first understand why home loan prepayment is considered a good idea;

When you make a prepayment towards your home loan, or any loan for that matter, the prepayment amount goes towards your principal payment. This results in a reduction in the total outstanding amount. Hence, from next month onwards, the interest is calculated only on the outstanding principal amount.

Furthermore, the interest portion of your EMI gets reduced from the next month, and the principal portion gets increased. Consequently, your principal gets repaid faster, and the total interest outgo is saved substantially. It helps your home loan get closed much earlier than you expected while availing of the loan.

However, some borrowers completely forget that they have an option of home loan repayment, while some do not opt for it thinking the bank or Housing Finance Company (HFC) will charge them for loan prepayment.

Take note that if you have availed of a home loan at a floating interest rate, no lender can charge you for prepayment of the loan. However, the lender may charge you with prepayment for a fixed-interest rate loan. Since most home loans are availed at a floating interest rate, prepayment charges should not be the thing you should worry about.

If you have surplus funds every month after paying your home loan EMI and other household expenses, you should consider opting for increasing your home loan EMI amount or request an auto-debit of a small amount from your bank account towards your home loan account. This will ensure you regularly make a repayment towards the principal amount, which will help you reduce your debt burden and interest outgo.

It is advisable to consider pre-paying your home loan in the below-mentioned situations:

1. When you have surplus funds parked in low-yield fixed-income products:

The interest rate charged on the home loan is higher than the returns generated by fixed-income products like fixed deposits. So, if you have any surplus funds parked in such investment products that may not yield more than the home loan interest rate, it makes sense to liquidate them and opt for home loan prepayment.

However, if you have kept these funds for contingencies or any other goal, make sure you have another financial plan to achieve those goals before liquidating them. It is not a good idea to put all your money towards home loan repayment as it can put you in a financial crisis.

Also, liquidating long-term investments that are capable of yielding better returns than your home loan interest rate, such as equity mutual funds, is not advisable as it may not help in saving money, which is the ultimate purpose of loan repayment.

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2. When you pay higher annual interest:

A home loan can save a significant amount of tax outgo as it comes with multiple tax benefits. The interest paid in a financial year is eligible for deduction of up to Rs 2 Lakhs under Section 24(b) of the Income Tax Act, 1961. The maximum deduction of Rs 2 Lakhs is applicable only for the interest paid on a self-occupied house property. And there is no upper limit on the let-out property. You can claim the deduction from the year the construction of the house is completed.

So, if you fall under the 20% to 30% income tax bracket, you can end up saving an annual tax of Rs 40,000 to Rs 60,000, respectively. Prepaying a home loan will reduce your interest outgo, and you will not be able to take advantage of this tax benefit.

If the post-tax returns on your investments are higher than the post-tax returns on the home loan, it can prove to be beneficial to keep the home loan going without prepayments.

Therefore, if you have any surplus funds after taking advantage of the tax benefit on the interest payment, i.e. you are paying more than Rs 2 lakhs towards the home loan interest portion, it makes sense to make home loan prepayment.

3. When you are not fully utilising deductions under Section 80C:

The principal amount paid is eligible for a deduction of up to Rs 1.5 lakhs under Section 80(C) of the Income Tax Act. However, if you sell the property within 5 years from the date of possession, it will be considered income in the year of sale. So, if you wish to enjoy the tax benefits of a home loan, you may consider continuing with your home loan.

In case you are paying less than Rs 1.5 lakhs towards the principal repayment of your home loan and do not invest in other avenues that qualify for tax deduction under this section, it is advisable to opt for a home loan prepayment as any amount paid more than a fixed EMI goes towards the principal.

For example, let us say out of your annual home loan EMIs, Rs 80,000 goes towards the principal payment. Your total 80C investments, like life insurance premium, child's school fees, 5-year lock-in FD, etc., total up to Rs 50,000. In this case, in order to take full advantage of deductions under 80C, it makes sense to make a home loan prepayment of Rs 20,000 annually.

4. When you do not need tax benefits on a home loan:

If you already have multiple provisions for taxation and do not require additional tax benefits on home loans, you may consider prepaying the home loan if you have surplus funds.

Know that home loan is a low-interest loan compared to other loans. So, if you have other high-cost loans like personal loans, car loans, etc., going on, it is advisable to consider getting rid of them first after considering the prepayment charges.

Also, when making a home loan prepayment, any amount; big or small, makes the difference in the final interest outgo. So, do not wait to save 'enough' money to make the prepayment. You can even make small prepayments of Rs 1,000 every month, which can save a considerable amount of interest.

To conclude:

While it may sound tempting to get debt-free at the earliest, especially in the current rising interest rate scenario, it is crucial to do a cost-benefit analysis considering the tax benefits and other investment opportunities.

It makes sense to keep a certain amount of home loan going on to take the maximum tax benefit. However, if you do not need the home loan tax benefits and are not confident about the high returns generating investment avenues, it is advisable to clear the debt as soon as possible.

Make sure you do not liquidate the investments made specifically for other goals and emergencies to prepay the home loan as it can put you in a cash crunch and you might end up taking a high-cost loans to fulfil your cash requirements in the future.

Warm Regards,
Ketki Jadhav
Content Writer