Prepaying a home loan is a great idea because it saves you from stress of paying EMI’s (Equated Monthly Installments).
There are different ways to prepay a home loan; however, you may choose a particular prepayment method over others depending on several factors such as your monthly earnings, investment options and liquidity.
Choosing the right prepayment method is key to your happiness because choosing to prepay your home loan the wrong way can lead to stress and regrets.
Here are some common traps that home buyers fall into when they blindly go for a prepayment.
Trap #1: Using Savings to Close a Loan
Using a large chunk of your savings to close a loan is not always a good idea. You may be forced to take a personal loan in the event of any emergency which means you will have to pay a higher rate of interest than your home loan. It also means you lose out on a potential investment option that could pay you better returns.
Trap #2: Refinancing via Loan Takeover
Many banks offer refinancing options to home buyers in order to
- Lower their EMI
- Reduce the loan tenure
Basically, the bank takes over an existing loan at a lower rate.
To do you this favor, banks often charge a hefty one-time fee in terms of processing charges. More often than not, this one-time fee would be much higher than the amount you would save by getting a lower EMI on your refinancing.
Consider this aspect while going for refinancing product.
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Trap #3: Increasing EMI to Prepay
Homebuyers who have salaried jobs often decide to prepay a loan by increasing their EMI when they get increments. While this is a wise decision, it also reduces your chances of going for further loans.
Banks usually fix an EMI to income ratio while disbursing loans. If you go beyond this ratio by increasing your EMI, then it will limit the size of your future loans.
Rather than, increasing your EMI, you may go for alternative investment options that yield higher interest rates.
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Trap #4: Home Saver Loan or Smart Loan
A home saver loan or smart loan is one where the bank allows you to open a current account associated with your home loan account.
The interest on your home loan is calculated on the amount that remains after deducing the balancing your current account.
Theoretically, a smart loan allows you to access the current account balance in emergencies while earning an interest on it that is equal to the rate of your home loan.
However, a smart loan also largely decrease your chances to earn a higher interest rate (than your home loan rate) on alternative investment opportunities.
Moreover, if you fail to maintain a sufficient average balance in your current account, it may not be much help to you.
Trap #5: Prepaying Later during the Loan Tenure
Prepaying is a good idea in the early years of your loan tenure because the interest rate is usually higher in the beginning of your payment schedule. As you pay off your EMI’s, the interest goes down and the principal amount goes up. Therefore, it makes sense to prepay your home loan only in the early years of your loan tenure.
That said, some banks may stipulate a minimum number of years of EMI before you’re able to prepay. You need to check with your bank either at the time of applying for a home loan or before considering a prepayment.