How prepayments help reduce home loan burden

We borrowers are always looking for ways to save costs. Many of us opt for prepayment of loan for the same reason. It saves us quite a large amount, given we follow all the conditions properly. But in many cases, this is accompanied by an expense in the form of a prepayment penalty.

Arti, 36, is working in a private company on a salary of Rs. 15 lakh per annum. She is looking for a loan that can be paid off before the due date as she would like to undertake additional financial activities in the future. She has a choice of two loans, both lending her Rs. 50 lakh at 10 per cent interest rate. But they have different conditions related to the prepayment penalty. The first one has the penalty calculated on the amount prepaid while the second has this based on the amount outstanding.

Analysis
Prepayment means the repayment of a loan before its decided schedule. It leads to a potential loss of income for the lender. Thus, to discourage borrowers from paying loans before the scheduled time they are slapped with a penalty.

In Arti's case, two different types of prepayments - part and full - are possible in the two loans. Hence, the prepayment penalties in both the loans will be different.

A) Part prepayment
When a borrower prepays only a part of the loan, it is called as a part prepayment. This is the case with Arti's first home loan. Such loans have a facility whereby a percentage of the loan can be repaid without a penalty, which is 5 per cent per year in case of Arti's first loan. The maximum amount that can be repaid in a year stands at 25 per cent of the total capital outstanding. If any amount in excess of 5 per cent is repaid, a penalty of 3 per cent will be levied.

a) So if at the end of three years, Arti has around Rs. 4,600,000 outstanding on her loan, she will be able to repay Rs. 230,000 in the year without a penalty.

b) If she plans to repay a higher amount, say Rs. 300,000, then there will be a penalty of Rs. 9,000. Note that she cannot repay the entire amount outstanding in a single year.

B) Full prepayment
A borrower goes for the full prepayment of the home loan when he/she switches bank for a better deal. In this type of prepayment, the bank suffers on account of the loss of interest and an asset liability mismatch that occurs due to the change. Here, the penalty is based on a specific percentage.
Note :
These loans do not allow part prepayment as in the first loan offering being considered by Arti.

When can Arti switch her loan?
For Arti, a potential switch situation could arise if she is offered home loan at 7.5 per cent by another bank. In that case she would like to ensure that the existing amount of Rs. 4,600,000 is repaid to the previous lender and the amount shifted to the other bank. She might even have the necessary amount in the bank, which would repay the entire amount and settle the loan. In case of this loan, this action will be possible but there will be a penalty of 2 per cent that will come into effect. This figure is important but many people do not even know that this exists. In such a situation, there is no alternative for Arti but to pay the total sum of Rs. 92,000, which is a cost for her. This has to be considered with the savings on account of the rate change over the years to see whether the prepayment is feasible.

What should Arti do?
Arti should select the home loan depending upon the amount of money she will have in the future and how she proposes to tackle the loan. If she is planning to just prepay small amounts each year then she can try and ensure that this remains below the 5 per cent level. This will go on to reduce her cost burden for the home loan. If the plan is to liquidate the whole loan then there will be a choice of the second option but the cost of prepayment always needs to be considered to see where the burden is reduced in an effective manner.