Home Loan prepayment is one of the most difficult decisions to make. I personally have a home loan running from 2004 till now and have not thought about closing it. Saving taxes vs Part repayment of the loan vs Investing the repayment amount in some other assets – all of us are torn between making this decision. This blog looks at different aspects which can help you make this decision.
Firstly, it is very important to understand how a home loan works. How do the banks make profit from the loans they give us? The EMI (Equated Monthly Instalments) is used to pay the Principal amount and the interest to the Bank. Now let us look at how each payment is split into Principal Component and Interest Component. We will do this by taking an example of a loan repayment schedule.
Home Loan repayment Schedule
Secondly, see the repayment schedule for a 12,00,000 (12 Lakhs) loan at 7.57% for a period of 20 years. Please look at the EMI, principal and interest figures and their trend over next 20 years.
Front loaded interest payment
Interest calculation is purely based on how much principal remains to be paid by us. Hence, more the principal, more the interest to pay. So we pay more interests at the start of the tenure.
Backloaded principal payment
We are always paying the same amount yearly. Since we are paying more interests at the start, we end up paying lesser principal at the start of the tenure.
Principal/Interest payments become equal at the mid point of tenure
During the mid point of the tenure, our principal and interests become equal.
In the Part-2 blog, we will look at a prepayment scenarios and what factors have to be considered.
