The Prepayment Predicament

A Noida-based couple entered India’s real estate bubble in 2013. They invested in a housing project by a reputed builder in Neemrana, hoping that the Rajasthan government’s Special Economic Zone (SEZ) in the area, where a lot of Japanese enterprises were expected to set up shop, would help them earn handsome returns. Two years later, the couple bought another house in Noida’s Sector 46, this time for residential purposes.

The couple took home loans for both the properties and their total equated monthly instalments (EMIs) came to Rs 60,000. Little did they know then that this sum, which they were able to afford with their two jobs, will start feeling like a liability only five years later.

As the Covid pandemic took roots in 2020, it shook lives and livelihoods across the country. As uncertainty grew, even those with steady jobs started rethinking their finances. Ruby and Roshan Verma (names changed at the request of the couple) were among the many who wanted to secure their future by reducing liabilities and increasing savings.

Among the first financial decisions the couple took was prepaying their home loans. That’s when their ordeal with the home loan prepayment rules started.

Roshan, who is a retail banker, never thought that it could be challenging to prepay a home loan. “The rules are different for each lender. My lender allows prepayment of only two EMI equivalents per month (so if your EMI is Rs 25,000 per month, you can prepay only Rs 50,000 along with the original EMI in that particular month). We didn’t have a lump sum amount, so we adopted this approach. Although sometimes we had extra money, our hands were tied.”

Banks allow individuals to increase their EMIs; the extra amount goes towards repayment of the principal. While, typically, banks have an upper limit till which the EMIs can be increased, there is no limit on lump sum prepayment.

While Ruby and Roshan want to pay off their loans to secure their future, many borrowers choose to prepay when they have more funds at their disposal. And most of these prepayments are for home loans as they constitute a large part of the lending market.

With interest rates at record lows and confidence in the economy resurfacing, the home loan market is expanding. According to a report by credit information bureau CRIF High Mark, India’s housing loan market witnessed a rebound in the third quarter of FY21.

If you are among those who are looking to take a home loan anytime soon, it would make sense to know about prepayment rules too. Loan prepayment is advisable as it translates into huge savings in interest cost in the long run (see How Prepayment Can Help You Reduce EMIs). However, not being aware of the rules and regulations can put you in a tough spot. “Some of the rules are strange, and, like us, most home loan beneficiaries would be unaware of them. These things should be part of the counselling process when people avail of home loans in the first place,” says Ruby.

So what should you keep in mind before prepaying a loan? “Home loan prepayment should be based on the following factors: cash flow, income security, cost of capital and tax benefits,” says Renu Maheshwari, a Sebi-registered investment advisor and CEO and principal advisor at financial advisory firm Finscholarz Wealth Manager.

Plan In Advance

Repaying a home loan by increasing the EMI is sure to affect your cash flow, so proper planning is a must. “Home loan prepayment by individual borrowers does not carry any prepayment penalties, (when the loan is) on a floating rate of interest. Therefore, the only problem could be availability of funds,” says Raj Khosla, managing director of MyMoneyMantra, a loan aggregator.

Funds diverted to prepay a loan could lead to a shortage during a financial emergency. “Medical expenses are one of the key reasons for this. During the pandemic, banks saw major defaults among home loan borrowers,” says V. Swaminathan, CEO, Andromeda, a loan distributor. While one reason was the spike in medical emergency expenses related to Covid, the other was loss of jobs and regular income.

Therefore, make a budget and ensure that you have a financial cushion for emergencies before deciding to divert money towards EMIs. “There should be an emergency fund which should not be touched. Ideally, six months’ monthly expenses should be parked as emergency money, to be utilised in extremely unfavourable situations,” says Abhishikta Munjal, chief risk officer at IIFL Home Finance, a non-banking financial company.

Any extra income like bonus and incentives could also be used towards prepayments. “Make your money earn for you. Invest in high-yield avenues and use the earnings for part payments,” adds Munjal.

Calculate The Tax Implications

The principal as well as the interest payout towards a home loan offer considerable tax deduction benefits. You can get deduction up to Rs 1.5 lakh on the principal amount under Section 80C of the Income-tax Act, 1961, while interest payment up to Rs 2 lakh is deductible under Section 24 of the Act. Apart from this, additional tax exemption of Rs 50,000 is available for first-time home buyers under Section 80EE of the Act.

If you prepay your home loan, you will miss out on the tax savings. In the lower tax brackets, the impact is higher. “However, a home loan is a considerable debt, and for people in higher tax brackets, the savings on tax deductions are insignificant,” says Prashant Thakur, director and head of research, ANAROCK Group, a real estate firm.

Moreover, borrowers do not look at home loans as a tax-saving avenue since their primary purpose is to buy a home, adds Thakur. Home-buying has an aspirational value. “Most Indians hope to pay off their home loans sooner, since they will thereafter be free of a major monthly recurring expense via EMIs. The funds thus saved can be invested in other instruments such as stocks and mutual funds, which can garner good returns,” he adds.

When you pre-close your loan, the savings on interest are substantial, especially in the early stages as that is when the interest component is the highest. If you pre-close the loan in later years, the savings may not be significant. Do a cost-benefit analysis before making this decision.

Impact On Credit Score

Slowly and steadily, the Noida-based couple mentioned earlier pre-paid their home loan for the house in Neemrana. But another shock awaited them.

Roshan planned to take a smaller home loan to buy an office space. However, when he went back to the bank, he found that his credit score had taken a hit because he paid his earlier loan within seven years against the original tenure of 20 years. Credit scores help banks assess the creditworthiness of an individual based on spending and payments of loans and credit card dues.

“When I approached the bank from which I had borrowed, I was informed that when banks give loans for a specific period, they start a credit-profit cycle aiming for a transaction for a fixed period of time. But when people pay off their loan sooner than that, the cycle breaks and the credit score comes down,” says Roshan.

One needs to understand that prepaying a home loan does not naturally improve the credit score because regular EMI payments demonstrate your credibility. “Home loan is a secured long-term loan and a measurable parameter for the creditworthiness of the borrower. Pre-closure of a housing loan can result in ‘absence of measurable long-term repayment’. Pre-closure is also looked upon as a loss-making proposition by the bank. Therefore, getting a second loan may be more difficult after the prepayment of a previous one,” says Maheshwari.

However, this may not be true for all the lenders; many treat home loan prepayment as a positive. “Prepayment doesn’t lead to lowering of the credit score. Further, prepayment of home loan improves the creditworthiness because you are seen as financially comfortable,” says Khosla.

It’s best to find out the details of prepayment from the lender at the time of borrowing itself, so that you are not in for a nasty surprise later.

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Tax Benefits On A Home Loan

• Section 80C: Deduction up to Rs 1.5 lakh on the principal amount

• Section 24: Deduction on interest payment up to Rs 2 lakh

• Section 80EE: Exemption of Rs 50,000 for first-time home buyers

With inputs from Jyotika Sood