Prepaying your home loan
The home mortgage is the biggest, longest term debt any of us will ever take out. It commits you to paying thousands of dollars for decades, with no room for missing the occasional payment if times are tough. Most of us buy homes and choose mortgages than we can afford - miscalculate, and you risk losing your home in foreclosure when you default on your loan. The opposite approach is paying MORE with each mortgage payment, or prepaying your loan. This is probably one of the best investments you can make, instantly building equity in your home and reducing your mortgage balance. How does a loan prepay work? How can you payoff your home early? Easy. Let's explain. Most mortgages come with a few variables - interest rate, amount, and term.
Why do banks charge a prepayment penalty?
It is a practice adopted by banks across the world to primarily cover two kinds of costs.
1) Banks raise deposits at a cost and so, the funds come at a price. They may not have the right to prepay these deposits/loans back to their lenders and hence, may continue to incur a cost. The prepayment penalty helps the banks in mitigating these costs.
2) Apart from the cost of capital, there are several direct expenses banks have to bear. These include legal, technical services and origination fees. Banks work out agreements assuming such costs can be recovered over the full tenure of the loan. Any prepayment leads to a loss for the bank since it disturbs this calculation process. Levying a prepayment penalty makes up for the loss.
IMPORATNT POINTS TO CONSIDER BEFORE MAKING PRE-PAYMENT
1) Before you prepay, keep some money invested in modes that can be liquidated easily for unforeseen contingencies. Remember that once you prepay a HOUSING LOAN , that money cannot be borrowed back easily later on.
2) If you have any unsecured debt (credit card or personal loan), pay it off at once. No risk- free investment can ever give you a post-tax return that will be higher than the post-tax cost of such a loan. The difference is normally so high that even stiff prepayment penalties, in the region of 3 to 5 per cent will not change the decision.
3)Secured loans (and especially home loans) are a little more complex because they are low cost and may also have certain tax benifits , driving down their post tax cost. The decision should normally be taken in consultation with your financial consultant. As a rule of the thumb, (not applicable in all cases) however, it will normally make sense even to prepay the home loans as long as the prepayment charges do not exceed 2%. There are 2 big exceptions to this thumb rule. 1. Where the interest rates on the home loan are lower than the current ruling rate (for example, where you had entered into a fixed rate contract earlier) 2. If principal repayment of the home loan increases the amount of deduction under section 80C (this will happen if you are not fully utilising the Rs 1,00,000 limit of deduction under this section through other modes of investment such as life insurance premiums, contribution to provident funds, etc.
4) Be aware of the prepayment penalties applicable in your case. Often, customers are asked to sign loan documents with no mention of prepayment penalty. Thus, they are not even aware of what the actual prepayment charges are. Most consumers also do not retain a copy of their loan document. Hence, they have no record of their loan agreement at all. Remember to keep a photocopy of all the documents you sign. Banks are obliged to send you a copy of the loan document. If they don't, you can lodge an official request on the bank's website.
5) Prepayment penalties are not written in stone. Prepayment penalties can be negotiated if you have a good credit history. For a select few consumers, banks may sometimes also waive this penalty. They may be more inclined to ignore or reduce the penalty in situations where interest rates have been climbing after the disbursement of the loan and the loan carries interest lower than the market rates. Competition among banks can also force them to be kinder on their customers.
6) Save on prepayment charges by making partial pre-payments. Quite a few banks do not charge pre-payment penalty if the loan is prepaid partially. The definition of what constitutes partial pre-payment varies from bank to bank. You can make enough pre-payment to ensure that you still need to pay a few more EMIs (normally 12) to completely clear off the loan. This will ensure savings in pre-payment penalty and at the same time help you to save on high interest costs on a substantial portion of the loan.