Want to prepay your home loan? Here is how you can do it
1 EMI SHOULD BE AFFORDABLE
A smart borrower will never bite off more than he can chew. The loan EMI should not push you into a corner. Your car EMI should not exceed 15% of your net monthly income while personal loan EMIs should not cross 10%.
The monthly outgo towards all loans should not be more than 50% of your net income. The loan-to-income ratio should be within acceptable limits. If it is not, you will be forced to put other critical financial goals, like saving for retirement or your child’s education, on the backburner. Retirement savings become the first casualty in such circumstances.
Accuracy is critical when you compute your repayment capacity. Don’t take into account future income. Base your calculations on what you are earning now. Times are bad, and the 10% increment you may have based your projections on could actually be only 6% or even a flat 0%, if your industry goes into a tailspin. Missing an EMI or delaying a payment can seriously dent your credit profile and prevent you from taking loans in the future for other goals. Experts say that if the borrower can’t repay, he should contact the lender before the EMI cheque bounces. One way to make the EMI affordable is by extending the tenure.
2. KEEP TENURE SHORT AND SWEET
You must have heard about how keeping money invested for the long term reaps the power of compounding. Well, in loans it works just the other way. The longer the tenure, the bigger is the interest burden on the borrower. If you take a loan at 9.75% for 10 years, the interest outgo will be 57% of the principal amount. This figure jumps to 91% if the tenure is 15 years and shoots up to 128% for a 20-year loan. In 25 years, the interest outgo is 167% of the principal.
Borrowers are tempted to go for long-term loans because the EMI is lower and they enjoy tax breaks on the loan. But this is a misconceived strategy because they end up paying huge interest on the loan. Though tax benefits bring down the effective cost of the loan, they are still incurring an expense.
Unless the money can earn more than the effective cost of borrowing, it should be used to repay the outstanding sum.
In some cases, it may be necessary to take a long-term loan. Young people with low incomes may not be able to afford a short tenure. For them, the best option is to repay the loan as fast as possible by increasing the EMI. EMIs should be increased every year in line with the increase in income. This can dramatically reduce the loan tenure.
A 25-year loan can be finished off in 10 years if the EMI is increased by 10% every year. Even one extra EMI every year reduces the tenure by nearly six years. Now, that’s a good way of utilizing the annual bonus or tax refund.
3. DON’T IGNORE OTHER GOALS
For most Indians, their children’s education and marriage are critical financial goals. A parent will do anything to give his children the best. Though education of the child is important, it should not jeopardize your own future. Don’t dip into your retirement corpus to fund your child’s education. Education loans are easily available and bright students also get scholarships. But nobody is going to give you a loan for your retirement needs. Taking an education loan will not only keep your retirement kitty safe but also inculcate a sense of fiscal responsibility in the child, who has to repay it. What’s more, education loans also offer tax breaks so the effective cost of the loan comes down.
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This is Bhaven, certified financial planner.
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