Rate Cuts: What would you save by switching or pre-paying your home loan now?

The Reserve Bank of India (RBI) recently cut its repo rate by 25 bps in its August Monetary Policy announcements, which implies that banks, financial institutions, and housing finance companies are expected to either lower or maintain their lending rates. Rates on all sorts of loans including home loans should lower marginally. New borrowers will get cheaper home loans. But what about existing borrowers. Would a prepayment or loan transfer be a good idea right now?

Prepayment always saves you a lot of money on interest, more so in falling interest rate scenarios. Since mid-2014, the RBI has reduced the borrowing rate seven times. We sense there's a bottoming out of the interest rate, with little to no room left for further cuts.

It makes sense to prepay in the first half of the loan tenure (especially at the start of your loan) because you are actually prepaying the principal which reduces your interest burden. Towards the end of the tenure, prepayment is best avoided as you have already paid most of your interest, and since prepaying the remaining principal would lower your tax benefits.

CASE STUDY
It is a given that prepayment saves you considerable amounts of money, and it's even better at a time interest rates have fallen. To quantify these gains, let's take the hypothetical example of a borrower who had taken a loan of Rs. 20 lakh in August 2012 at a fixed BPLR (Benchmark Prime Lending Rate) of 9%. He has consequently, been paying a monthly EMI of Rs. 17,995 which amounts to Rs. 215,934 annually. Till date he has paid off five times this last sum which equals Rs.1,079,670 towards his total loan liability which is of course 20 times Rs. 2,15,934, or Rs.43,18,680 to be precise. If his loan amortization table is referred to, it would be found that his outstanding balance is Rs. 1,774,141 at the end of the fifth year - meaning as of today. However if he continues paying his EMI's he will end up paying double that amount over the remaining 15 years (Rs. 4,318,680 - Rs. 1,079,670 = Rs. 3,239,010).

SCENARIO 1
Assume he prepays Rs. 774,141 and switches to an MCLR (Marginal Cost of funds Lending Rate) linked loan with a bank. His outstanding would be Rs. 10 lakh @ 8.75% (post RBI's repo cut). His new EMI would now be Rs. 9,994. Annually he will pay Rs. 119,928 and for 15 years 1,798,920. Adding his prepayment to this amount we get Rs. 2,573,061, which is Rs. 665,949 less than what he would have paid otherwise. So he saves more than Rs. 6.5 lakh in interest which is a neat little sum.
 
SCENARIO 2
Let's continue from his prepayment now assuming that rates remain unchanged. Like before, his outstanding would again be Rs. 10 lakh. But his original rate of interest of 9% continues, and his EMI now is Rs. 10,143 for the remaining term i.e. 180 months. This means that he would pay a total of Rs. 1,825,740. Again adding his prepayment to this amount we get Rs. 2,599,881 which is marginally greater than the previous corresponding amount - Rs. 26,820 to be exact.

OPPORTUNITY COST
Now that we have established that prepayment is a beneficial practice - especially in today's context when prepayment penalties have been waived off or considerably reduced elsewhere (see miscellany below), it remains to be settled if this is only worthwhile cause towards which you can use your surplus funds or bonus income.

Of course, reducing the burden of a loan is a great thing. But there's something called Opportunity Cost which you must consider before prepayment. What if you invest the same amount in an equity-heavy mutual fund for, say, 15 years? Even if we assume that it gives a modest return of 15% per annum, what do you get at the time of maturity? You get a corpus of Rs. 6,299,233. It is easy to see that you make more than what you saved on interest after prepayment.

SWITCHING LENDERS
Most banks allow you to transfer one of your loans to the other with minimal paper work and penalty. However, an inter-bank switch or switching of lenders entails higher levels of paperwork and higher charges. You must always calculate the gross benefits of a loan transfer by understanding your transfer costs.

MISCELLANY
Most banks and lending institutions have made part prepayment penalty free and charge a reduced fee beyond a certain limit. A leading public sector bank has removed even this limit and you can prepay any proportion of your loan provided you prepay from your own account with the bank.

Here are some rules of thumb experts use for evaluating the option of prepayment.
1.    Better to prepay towards the beginning of a terms than at the end
2.    Between two loans, prepay the larger one first.
3.    Best to prepay when rates are falling.
4.    Prepayment saves you taxes under Section 80 C of the Income Tax Act.
5.    Always prepay from surplus disposable income.
6.    Chose prepayment over investing in stocks if you have a low risk appetite.

(The writer is CEO, BankBazaar.com)