Should You Reduce Your EMI or Loan Duration? A Guide to Home Loan Prepayments

Setting Up the Scenario

Consider a scenario where you have taken out a home loan of ₹50 lakh at an 8% interest rate for a 25-year term. In this case, your EMI would be ₹38,591 per month. Without making any prepayments, you would pay over ₹65 lakh in interest over the 25 years, resulting in a total repayment of more than ₹1.15 crore.

Options for Prepayments

You can make prepayments in several ways:

• Monthly Prepayments: Adding a little extra each month to your EMI.

• Yearly Prepayments: Making a lump sum payment once a year.

• Random Prepayments: Paying extra whenever you have additional funds, such as bonuses or gifts.

The Impact of No Prepayments

If you make no prepayments, you will continue paying ₹38,591 per month over 25 years, accumulating over ₹65 lakh in interest. However, making prepayments offers two options: reducing your EMI or shortening the loan term, each having different financial impacts.

Option 1: Reducing Loan Duration

Keeping your EMI the same while reducing the loan term allows you to pay off the loan faster and save more on interest. During the initial phase of a loan, a larger portion of your EMI goes towards interest rather than the principal. For example:

• Month 1: Out of ₹38,591, ₹33,333 goes towards interest, and only ₹5,257 towards principal.

• After 10 Years: ₹26,692 goes towards interest, and ₹11,670 towards principal.

• After 20 Years: ₹12,000 goes towards interest, and ₹25,903 towards principal.

The earlier you prepay, the more interest you save because a higher portion of your EMI goes towards reducing the principal amount.

Option 2: Reducing EMI

If you face financial constraints, you can opt to reduce your EMI while keeping the loan term the same. This option reduces your monthly financial burden but results in less interest savings over the loan's duration.

A Closer Look at Both Options

1. Small Prepayments Every Two Months: Prepaying ₹5,000 every two months can have different effects:

   • Reduce Term: Saves approximately ₹29,000 in interest.

   • Reduce EMI: Saves around ₹6,290 in interest.

2. Larger Prepayments (e.g., ₹50,000):

   • Reduce Term: Saves about ₹2.8 lakh in interest.

   • Reduce EMI: Saves only ₹6,277 in interest.

3. Late Prepayments (e.g., after 24 months): If you delay prepayments, the impact on interest savings diminishes significantly.

Scenario Analysis with Examples

1. Paying One Extra EMI Annually: Suppose you pay one additional EMI of ₹38,591 each year:

   • Reducing the Term: This will allow you to pay off the loan in 20 years instead of 25, saving ₹14.5 lakh in interest.

   • Reducing the EMI: This will decrease your monthly payments slightly but won’t significantly affect the repayment period or total interest.

2. Making Random Prepayments: If you receive a bonus and prepay ₹5 lakh in the 60th month:

   • Reducing the Loan Term: This action would allow you to pay off the loan in 17 years, saving over ₹24 lakh in interest.

   • Reducing the EMI: This keeps the loan term at 25 years but only saves around ₹3.4 lakh in interest.

Optimal Strategy for Maximum Savings

To maximize savings on your home loan, consider the following strategy:

• Pay One Extra EMI Annually: This reduces the loan term and saves substantial interest.

• Increase Your EMI by 10% Each Year: This accelerates loan repayment, allowing you to pay off a 25-year loan in just 10 years. This strategy can reduce your interest payment from ₹65.77 lakh to ₹26.82 lakh, saving around ₹4 lakh.
  
  

Conclusion

To optimize your home loan repayment:

1. Make Regular Prepayments: Focus on reducing the loan term rather than the EMI to maximize interest savings.

2. Pay One Extra EMI Annually and Increase EMI by 10% Each Year: This combination can significantly reduce your interest payments and loan duration.

3. Make Prepayments Early: The earlier you make prepayments, the more you save on interest due to a higher portion of EMI going towards the principal.

This approach not only saves a substantial amount in interest but also helps you become debt-free sooner, providing greater financial freedom. For more personalized guidance, you can use the downloadable Excel sheet provided in the video’s description to simulate different scenarios and understand the impact of your prepayment strategy on your loan. Take charge of your financial future and make informed decisions to achieve your financial goals.