Paying home loan EMI’s month-after-month is a burden. How to reduce home loan EMI? By making loan ‘prepayment‘. What is prepayment?
It is an extra payment made to ones home loan account in addition to the EMI. How prepayment helps? It reduces the loan outstanding faster.
But while one is making the prepayment, bank will ask the borrower, shall the prepayment be utilised to reduce EMI or tenure? What one must do? Which option is better?
This is what we will discuss in this article.
When I was making my first home loan prepayment, this question struck me unprepared. Anybody who has made a prepayment of their home loan, must have faced the same question.
Banks compulsorily asks this question to the account holder while receiving the prepayment amount. The problem is, most of us are not prepared for the answer. As a result, banks reduces the tenure by default.
There is no doubt that prepayment amount used for ‘tenure reduction’ is more profitable. But this doesn’t make EMI reduction obsolete. EMI reduction is also as effective.
I have written a separate blog post on prepayment of loan for tenure reduction and its advantages – check the link. I would utilise this space to talk more about prepayment for “EMI reduction”.
Why to Reduce Home Loan EMI?
People dream about buying a big home for self. But the limitation is obvious. Bigger house will cost more, and higher is the cost, more will be the EMI.
The problem with EMI is that, it’s a recurring expense. No matter what may come, the EMI will be debited from ones account on a fixed date of every month.
EMI’s are like an expense set on auto-mode. Hence, its long term psychological effect on the payee (a common man) is not positive.
It’s intensity becomes even more magnified when EMI is very high. Hence, it is in our interest to make loan prepayments and reduce the EMI burden.
What means by EMI reduction and tenure reduction?
Let’s understand this with an example. Suppose one took a home loan of Rs.65 Lakhs, @9% p.a. for 20 years. In this case the EMI will be Rs.56,409 for next 20 years. Total payment of Rs.1,35,38,042 – Interest plus principal.
This person decides to make a prepayment of Rs.1,14,000 in the 13th month. Now, he has two options:
- Reduce EMI: The person is currently paying an EMI of Rs.56,409. Upon prepayment of Rs.1,14,000 in 13th month, the benefits will be these:
- In Short Term: The estimated EMI reduction will be from Rs.56,409 to Rs.55,399 (Saving of Rs.1,010 each month).
- In Long Term: Over a period of time, due to reduced EMI, the person will pay only Rs.1,34,21,897. Which is a saving of Rs.1,16,145 (13538042 – 13421987).
- Reduce Tenure: Loan tenure on the first month was 240 months. What does it mean? Means the person will have to pay EMI’s for 240 months to pay it off. Upon prepayment of Rs.1.14 Lakhs in 13th month, the benefits are these:
- In Short Term: There will be no benefits, why? Because the loan EMI will remain the same at Rs.56,409 (Saving is Rs.0).
- In Long Term: Here there will be two benefits. First, the loan will be paid off in 231st month itself. Second, the person will pay only Rs.1,31,03,435. Which is a saving of Rs.4,34,608 (13538042 – 13103435).
So, tenure reduction is better than EMI reduction? On face of it, it looks like this. But a more detailed analysis will give alternative conclusion, why? Because type of savings made from EMI and tenure reduction are different. Lets know more…
Difference in type of savings
There is a distinction between the savings shown in the above table:
- In case of EMI reduction: Savings starts to happen immediately. From the next month itself, the borrowers starts to pay less EMI’s (Rs.1,010 less), till end of tenure – in 20th year. Read more about why to become debt free?
- In case of tenure reduction: Savings will be realised only when the tenure ends, why? Because the borrower will continue to pay the same EMI till the end of tenure. When the tenure ends (in 230th month instead of 240th), it is only then the benefit of the prepayment will be realised. Read about smart ways to become loan free.
Present Value of Future Savings
To fairly compare the benefits of EMI and Tenure reduction, we must use the concept of “present value“. Read more about the present value concept.
In our above example, the borrower has made a prepayment of Rs.1,14,000 in the 13th month, and eventually the money was saved. A representation of savings schedule has been shown below:
How to calculate the present value of all these future savings? By using Present Value formula of Excel [Present Value = PV(rate, nper, pmt, [fv])]. Read more about investment answers using excel.
- EMI Reduction: In our example, present value of all savings will be Rs.1,36,888 (= PV (6%/12, 227, 1010, 0).
- rate: discount rate = inflation = 0.5% p.a. (=6%/12) – [** 6% assumed inflation for next 19 years. 6%/12 = inflation per month.]
- nper: total number of savings months = 227nos (=240 – 13).
- pmt: savings in Rs. per nper = Rs.1,010.
- fv = Lump-sum saving at end = Rs.0.
- Present Value = Rs.1,36,888.
- Tenure Reduction: In our example present value of all savings will be Rs.1,51,524 ( = PV (6%, 18.08, 0, 434608)).
- rate: discount rate = inflation = 6% p.a.
- nper: total number of savings years = 18.08 [=(230 – 13)/12].
- pmt: savings in Rs. per nper = Rs.0.
- fv = Lump-sum saving at end = Rs.4,34,608.
- Present Value = Rs.1,51,524.
[P.Note: The ‘quantum of savings’ estimated by present value method will be different from one shown in above flow chart].
What we can conclude?
|Description||EMI Reduction||Tenure Reduction|
|Overall Savings (Rs.)||1,16,154||4,34,608|
|Present Value of all |
If we’ll see only superficially, as shown in the above flow chart, it looks like ‘tenure reduction’ is far more rewarding than ‘EMI reduction’. But when we see it through the prism of “present value”, the difference is not much. Hence, I would like to conclude it like this:
- At Par: On computing present value of all future savings envisaged after prepayment, EMI reduction and Tenure reduction is almost at par. But still, tenure reduction is slightly more profitable. Read more about tips and tricks to save money.
- Role of Banks: Banks will not tell us that tenure & EMI reduction are almost similar. They would like us to believe that tenure reduction is better, why? Because if EMI is high, banks collect more each month. Moreover, in this case the loan also gets over faster (hence less risk for banks). Read more about debt traps.
- Use saved EMI: If the difference is so small, as a borrower, I would rather reduce the EMI upon prepayment, why? Because the money saved on EMI, can be reused to make more prepayment in future. Also, I can invest the saved EMI in (say) a mutual funds for fast capital growth. Check this SIP return calculator.
I’ve prepared two excel based prepayment calculators. One calculator is to check potential savings from EMI reduction, and other is for tenure reduction.
You can check my blog post on how to use my excel based prepayment calculator (for EMI reduction).