Prepaying your mortgage may seem like a good idea, but it can have unintended consequences if you don't plan it out carefully.
Customers can now anticipate processes that do not involve paper or their physical presence. To obtain a loan, all that is required of them is to go to the website, and once the e-verification process is complete, the money will be transferred to their bank accounts.
Equated monthly instalments, also known as EMIs, are a significant portion of the cash outflow that is incurred by the majority of homebuyers. The tendency is to prepay the loan as soon as it is financially feasible to do so.
Using savings to pay off the loan partially or wholly
It is a very alluring choice to have the ability to pay off the outstanding amount and have the entirety of your income available for spending as you see fit. In this scenario, the loan is closed after the homebuyers prepay the remaining balance of the loan using their own savings.
Even though this is a good choice, it will result in you having no cash left in your possession.
In the event of an unexpected emergency, when you might require funds right away, this obviously has repercussions. In this scenario, the prospective homeowner might be forced to take out a personal loan instead of a mortgage, which carries an interest rate that is significantly higher than that of a mortgage, resulting in an even greater amount paid back in interest.
The other unfavourable aspect is the possibility of missing out on a more lucrative investment. If you can find an alternative investment option where the rate of return is higher than the rate of your home loan, you should select the investment rather than making a prepayment because the rate of return on the investment will be higher.
Refinancing loan takeover from another financial institution
When paying off a mortgage early, this tactic is frequently utilised. Homebuyers sometimes come across offers from banks that are willing to take over the existing outstanding loan at a lower rate. This can shorten the amount of time it takes to pay off the loan or reduce the monthly payment amount. This is a preferable choice because it does not have an effect on your savings while at the same time contributing to a reduction in the overall amount of interest paid during the loan's term. The banks' processing fees and other fees (if there isn't also a prepayment penalty), which they charge for refinancing as well as closing out a home loan, are the source of the problem, however.
Sometimes the difference in interest rates is so small that you may end up paying more in one-time fees than the amount of money that you can save by having your EMI lowered.
Increasing the EMI plan to prepay the loan before the tenure
Home buyers who have steady incomes often choose this path because it's less stressful. The disposable income of salaried borrowers typically increases over the course of their careers as a result of promotions, raises, and other pay-related benefits. A more prudent choice would be to increase the monthly installment amount (EMI) and pay off the loan earlier, as opposed to spending money on things like new clothes, vehicles, or electronics.
In this scenario, even if you accelerate the payment on your loan, you will find it increasingly difficult to obtain additional loans. For the purpose of loan disbursement, financial institutions will typically use something called an EMI to income ratio (also known as a Fixed Obligations to Income Ratio). Clearly, increasing your EMI above and beyond what is suggested by this ratio will result in a reduction in the amount of future loan you are eligible for.
Home equity loan or alternative loan
The provision of a current account in conjunction with the home loan account is a service that has only recently been made available by financial institutions. The difference between the amount of the outstanding loan and the balance in your current account is the amount that banks use to calculate the interest on loans; this results in a lower monthly installment payment (EMI). Home buyers can take advantage of lower EMIs and access this fund in the event of an unexpected emergency thanks to this provision. In essence, the interest you earn on the deposit you make into your current account is equivalent to the interest rate on your home loan.
The issue here is that if you have access to a superior investment opportunity, you are forgoing the possibility of higher returns. If you do not invest in the alternatives that have the potential to give you higher returns, you will incur a high opportunity cost. In addition, you should not choose this alternative if you do not anticipate having a current account balance that is consistently above a certain threshold.
Prepaying later during loan tenure
Regarding a mortgage, Compared to the principal amount, the interest portion of an EMI is greater at the beginning of the payment schedule. As you continue to make payments, the interest portion of the balance starts going down while the principal portion goes up. As a result, making any prepayments at the beginning of the loan's tenure, rather than later on in the payment schedule, makes the most sense financially. It's possible that you won't save much in terms of interest payments if you prepay later; however, doing so will deplete your vital liquidity. Before you are allowed to prepay your EMI loan, some banks require that you have completed a certain minimum number of years of payments. Verify the information with the bank, and make your choice based on it.
Pitfalls
Paying off the loan with money that was saved: It removes any and all cash from your possession, which could be problematic in the event of an unexpected expense. You also miss out on potentially more lucrative investment opportunities.
Refinancing through the purchase of an existing loan by another bank: It consists of processing fees and other fees that banks charge for refinancing as well as closing costs for a home loan.
Increasing the monthly installments amount in order to prepay the loan before the term: Reduced likelihood of being able to secure additional loans
Prepayment made at a later time during the term of the loan: It is more beneficial to make a prepayment at the beginning of the loan term as opposed to making one later in the payment schedule.
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