'Home loan interest rates increased'. Isn't this what you get to read in newspapers nowadays?

Just when you have finished reading the report your spouse reminds you about her/his impending bonus next month. That sets the ball rolling and you immediately think of prepaying your home loan.

Do you find yourself in a similar situation? Do you have a home loan outstanding, on which interest rate has increased? Are you expecting a one-time lump sum amount from your bonus or some such thing? If yes, and if you are planning to prepay your home loan then here's what you must know that will help you with this rather difficult decision:

 ~ Before you prepay keep some money invested in modes that can be sold off easily for cash to manage unforeseen contingencies. Remember that once you prepay a loan that money cannot be borrowed back easily later on. 

~ 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 should not make you change the decision to repay unsecured loans first.  

~ Secured loans (and especially home loans) are a little more complex because they are low cost and may also have certain tax benefits driving their post tax cost down. 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 per cent of your outstanding loan amount. There are two big exceptions to this thumb rule:

• Where the interest rates on your home loan are lower than the current ruling rate (for example where you had entered into a fixed rate contract earlier).
• 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).

~ Beware 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 concerned bank's website. If they still do not provide the documents you can also complain to the banking ombudsman. (www.rbi.org.in)

~ Prepayment penalties are not written in stone. Prepayment penalties can be negotiable 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 lower than the market rates of interest. Competition among banks can also force them to be kinder on their customers.  

~ Save on prepayment charges by making partial prepayments. Quite a few banks do not charge prepayment penalty if the loan is prepaid partially. The definition of what constitutes partial prepayment varies from bank to bank.

You can make enough prepayment 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 prepayment penalty and at the same time help you to save on high interest costs on a substantial portion of the loan.  

Prepayment Myths 

Some people think that it may be beneficial to prepay the home loan only early in its tenure and not after it has passed the mid way mark. This is a complete myth.

You may think that the EMI (Equated Monthly Installments) will, for the remaining part of the repayment period, mainly go towards clearing the principal amount as much of the interest portion has already been paid off. Even though this is true, the effective cost of the loan remains the same. Hence your decision should not change based on how much tenure of the loan has already elapsed.

~ Just a final word of caution before you prepay: Make sure that you have enough reserves set aside to see you through a rainy day or a sudden crisis that can crop up from nowhere. Or else, you will be forced to repeat the cycle: another loan, another interest rate structure, and yet another saga of prepayment penalties.    

Summary: 

• Prepay after you have set aside money for emergencies.
• Priority should be to repay unsecured loans like credit cards and personal loans where interest rates are high.
• Banks may waive off prepayment charges if you negotiate.
• At whatever stage of the loan, it is cheaper to prepay.

Apnaloan.com is a guide to home loans in India. Apnaloan also enables consumers get best home loan rates by making banks compete for their loan.