Home Loans: How to lower the EMI and lower the Term?
Whether to take home loans for a longer term or for shorter term?
We all know that, if we loan term is reduced EMI will go higher and if the loan term is increased the EMI will come down.
Advantages of having a shorter tenure:
1. We are debt-free very early. Being debt-free brings us a peace of mind, which won't be possible if you are in debts.
2. Less out go of cash due to interest. Longer the term, longer will be the total money you have paid.
For a 1 lakh loan for 10 years, the EMI is Rs 1,377.50 at 11% interest rate, where as for 20 years, the EMI is Rs 1,032.19. So the total cash out flow is Rs 1,65,300.00/ and Rs 2,47,725.60 respectively. This is the power of compounding. Here the Eight wonder of the world as quoted by Albert Einstein, is working against us.
3. Increased liability needs increased insurance cover, hence the insurance cost will also be high if the loan term is longer.
4. Increase in interest rate, can be handled much comfortably by extending the term. (i.e. 10+2 years is comfortable than 20+2 years.)
Advantages of having a longer tenure:
1. EMI is less. Hence, we can comfortably pay the EMI without any defaults and we may be eligible for higher loan amount.
Is it possible to get the advantages of both lower term and lower EMI?
Partially yes, Partially No. Yes, if you are disciplined, you can prepay the loan, a couple of years early, for the same EMI. No, you can't get higher loan from a HFC or a bank.
You have to take a house loan for Rs 15,00,000/ and at the interest rate of 11p.a. For simplicity, I am taking a fixed rate, and let us assume, it is pure fixed rate loan, as available in HDFC, ICICI etc. (Some HFC's and Banks have a maximum fixed term as 5 years or 2 years, etc.)
It is assumed that, you are eligible for any term of 10 years, 15 years or 20 years.
Analyze your financial abilities, responsibilities and liabilities and decide on the tenure. Let us say, you want to pay the loan in 15 years. So, the EMI is Rs 17,048.95/ That is, you can pay this amount Rs 17,049/ without any problems for 15 years. Also, you have came up with this figure after considering the tax deductions also. So, in our computation, we are going to ignore the tax savings advantage.
Now, apply for the home loan for 20 years, instead of 15 years. So, your EMI is Rs 15,482.83. Hence the reduction in EMI is Rs 1566.12/ Now, invest this amount in a diversified mutual fund. Since the time period is long, the risk accompanying this investment is negligible. Let us assume a conservative returns @15%.
A simple calculation will show us that, at the end of 15 years, the value of our investment will be 1,060,048.83/ But the outstanding balance with us will be Rs 712,102.13. Withdraw the investment and prepay the loan. Now, you will be left with Rs 3 lakhs additional cash. You should also consider the prepayment penalty. Usually 2% of the prepayment amount, that is around 14,000. Many banks have no prepayment penalty up to some specified amount. Example, IDBI has around 25% of outstanding balance, in every 6 months, citi bank has around 25% every year. So, Instead of closing the loan, all at once, you can make a systematic withdrawal and prepay the loan, thus, avoiding the prepayment penalty and also redeeming at a depressed market.
So, we will be left with approximately 20% of the loan value in our hand.
Currently we have kept the tenure and monthly liability (EMI + investments) at the same level, and generated an extra cash of 20%, at almost no risk.
What if the interest rate is not fixed through out the term, but part fixed i.e. only for 5 years?
Still, apply the same rule for the fixed tenure. At the end of 5th year, if the interest rate is higher, you can either use the savings the prepay the loan, thus reducing the EMI, increase the loan term, with the same EMI, and continue investing at higher rate, at the end of 15 years, you will most likely end up with a higher investments. But, do the home work properly, if the interest rate is too high i.e. greater than or equal to 15%, then it is better to increase the EMI, but if it is lesser than 15%, we can keep the EMI same as we can generate better returns.
You should also consider investing more amount in mutual funds, if required, to generate more value in order to prepay the loan at the exact tenure.
Interest rate at the 1 st year : 11%
Interest rate at the 6 th year : 13%
Interest rate at the 11th year : 14%
Interest rate at the 16st year : 14%
Strategy 1:
Always prepay the loan, before every hike.
Here inspite of the increased payments, we have ended up prepaying the loan by 2 years and saving a cash in hand of Rs 53,593/
In our case, the interest rate kept on increasing. But, if the interest rate came down, saw from 11% to 10% or even if it retained the same, we need not prepay the loan, instead we can continue paying a low EMI and investing more in mutual funds. In fact, if we have the option to lower the EMI and keep the loan term as the same, we can do that.
Strategy 2:
Always keep the EMI same, and increase the loan period. The bank may not cooperate well with you, but if you can convince the banker, you can apply this strategy. Although this strategy doesn't have much risk, iinfact lesser risk as we will won't take out the mutual fund investments withing 15 years at any case, and we also won't very the monthly investment. But, this may affect your peace of mind. If you follow it with full discipline, this will be a better strategy.
You can pay all at once. So, although the tenure as per the bank will be around
35years, you have paid the loan in just 16 years.
The problem with this technique is, at some point of time, your loan statement will say, you will be in debt for 35 years. So, the bank may not cooperate well with you.
Use this only if the expected % from the market is much higher than that of the interest rate.
Strategy 3:
You can also mix and match both these two techniques, in such a way that you can arrive at a best combination at any point of time.
In all these techniques, I haven't considered the tax savings. If you included the amount of tax saved also, you will be able to handle the interest rate hikes, better, and also, you will be able to prepay the loan much faster, or even create greater wealth.
Points to consider while considering the tax benefits:
The more tax you save, better it is. As we are investing the same amount, whether it is principal repayment or as interest, the total out flow is the same. Hence higher savings in tax should be preferable. So, always restructure the EMI in such a way that you will get higher tax benefits.
In such a case, the strategy 2 will prove to be very efficient than others. Because, in this strategy, we pay interest of more than 1.5 lakhs for around 15 years, which by itself gives around Rs 50,000/ Investing this in mutual funds, will generate a return much higher that you will be able to prepay the loan within 13 years.
If the property you buy is to let out, then you will not have the 1.5 lakhs cap for interest payment, there by producing a better returns.
Conclusion:
Use equities for long term wealth creation. Use leveraging appropriately. Although this works well with home loans, you should not apply the same technique with personal loans as the interest rate is 16%, but our expected earnings in stocks is just 15%. Also, don't be greedy, don't expect 30% return from the market. Market always surprises you.
If you can invest much higher, you
We all know that, if we loan term is reduced EMI will go higher and if the loan term is increased the EMI will come down.
Advantages of having a shorter tenure:
1. We are debt-free very early. Being debt-free brings us a peace of mind, which won't be possible if you are in debts.
2. Less out go of cash due to interest. Longer the term, longer will be the total money you have paid.
For a 1 lakh loan for 10 years, the EMI is Rs 1,377.50 at 11% interest rate, where as for 20 years, the EMI is Rs 1,032.19. So the total cash out flow is Rs 1,65,300.00/ and Rs 2,47,725.60 respectively. This is the power of compounding. Here the Eight wonder of the world as quoted by Albert Einstein, is working against us.
3. Increased liability needs increased insurance cover, hence the insurance cost will also be high if the loan term is longer.
4. Increase in interest rate, can be handled much comfortably by extending the term. (i.e. 10+2 years is comfortable than 20+2 years.)
Advantages of having a longer tenure:
1. EMI is less. Hence, we can comfortably pay the EMI without any defaults and we may be eligible for higher loan amount.
Is it possible to get the advantages of both lower term and lower EMI?
Partially yes, Partially No. Yes, if you are disciplined, you can prepay the loan, a couple of years early, for the same EMI. No, you can't get higher loan from a HFC or a bank.
You have to take a house loan for Rs 15,00,000/ and at the interest rate of 11p.a. For simplicity, I am taking a fixed rate, and let us assume, it is pure fixed rate loan, as available in HDFC, ICICI etc. (Some HFC's and Banks have a maximum fixed term as 5 years or 2 years, etc.)
It is assumed that, you are eligible for any term of 10 years, 15 years or 20 years.
Analyze your financial abilities, responsibilities and liabilities and decide on the tenure. Let us say, you want to pay the loan in 15 years. So, the EMI is Rs 17,048.95/ That is, you can pay this amount Rs 17,049/ without any problems for 15 years. Also, you have came up with this figure after considering the tax deductions also. So, in our computation, we are going to ignore the tax savings advantage.
Now, apply for the home loan for 20 years, instead of 15 years. So, your EMI is Rs 15,482.83. Hence the reduction in EMI is Rs 1566.12/ Now, invest this amount in a diversified mutual fund. Since the time period is long, the risk accompanying this investment is negligible. Let us assume a conservative returns @15%.
A simple calculation will show us that, at the end of 15 years, the value of our investment will be 1,060,048.83/ But the outstanding balance with us will be Rs 712,102.13. Withdraw the investment and prepay the loan. Now, you will be left with Rs 3 lakhs additional cash. You should also consider the prepayment penalty. Usually 2% of the prepayment amount, that is around 14,000. Many banks have no prepayment penalty up to some specified amount. Example, IDBI has around 25% of outstanding balance, in every 6 months, citi bank has around 25% every year. So, Instead of closing the loan, all at once, you can make a systematic withdrawal and prepay the loan, thus, avoiding the prepayment penalty and also redeeming at a depressed market.
So, we will be left with approximately 20% of the loan value in our hand.
Currently we have kept the tenure and monthly liability (EMI + investments) at the same level, and generated an extra cash of 20%, at almost no risk.
What if the interest rate is not fixed through out the term, but part fixed i.e. only for 5 years?
Still, apply the same rule for the fixed tenure. At the end of 5th year, if the interest rate is higher, you can either use the savings the prepay the loan, thus reducing the EMI, increase the loan term, with the same EMI, and continue investing at higher rate, at the end of 15 years, you will most likely end up with a higher investments. But, do the home work properly, if the interest rate is too high i.e. greater than or equal to 15%, then it is better to increase the EMI, but if it is lesser than 15%, we can keep the EMI same as we can generate better returns.
You should also consider investing more amount in mutual funds, if required, to generate more value in order to prepay the loan at the exact tenure.
Interest rate at the 1 st year : 11%
Interest rate at the 6 th year : 13%
Interest rate at the 11th year : 14%
Interest rate at the 16st year : 14%
Strategy 1:
Always prepay the loan, before every hike.
Loan amount : 15,00,000.00
Tenure : 20 years
5 years fixed
Rate of Interest : 11%
EMI : 15,482.83
After 5 years:
Outstanding Balance : 13,62,209.01
Remaining Loan Term : 15 years
New Rate of Interest : 13%
Amount that can be prepaid : 140,441.53 (From investment from reduced emi)
Outstanding Balance : 12,21,767.48
New EMI : 15,458.32
After 10 years:
Oustanding Balance : 1,035,311.82
Remaining Loan Term : 10 years
New Rate of Interest : 14%
Amount that can be prepaid : 142,650.39 (From investment from reduced emi)
Outstanding Balance : 892661.43
New EMI : 13,860.04
or
New Term for same EMI : 8 (EMI = 15,506.87)
Choosing same EMI:
After 15 years:
Oustanding Balance : 453,714.00
Remaining Loan Term : 3 years
New Rate of Interest : 14%
Amount that can be prepaid : 138,296.34 (From investment from reduced emi)
Outstanding Balance : 315417.66
New EMI : 10,780.23
or
New Term for same EMI : 2 (EMI = 15,144.11)
At the end of 17th year :
Amount from investment : 53,593.50
Here inspite of the increased payments, we have ended up prepaying the loan by 2 years and saving a cash in hand of Rs 53,593/
In our case, the interest rate kept on increasing. But, if the interest rate came down, saw from 11% to 10% or even if it retained the same, we need not prepay the loan, instead we can continue paying a low EMI and investing more in mutual funds. In fact, if we have the option to lower the EMI and keep the loan term as the same, we can do that.
Strategy 2:
Always keep the EMI same, and increase the loan period. The bank may not cooperate well with you, but if you can convince the banker, you can apply this strategy. Although this strategy doesn't have much risk, iinfact lesser risk as we will won't take out the mutual fund investments withing 15 years at any case, and we also won't very the monthly investment. But, this may affect your peace of mind. If you follow it with full discipline, this will be a better strategy.
Loan amount : 15,00,000.00
Tenure : 20 years
5 years fixed
Rate of Interest : 11%
EMI : 15,482.83
After 5 years:
Outstanding Balance : 13,62,209.01
Remaining Loan Term : 15 years
Amount available : 140,441.53 (From investment from reduced emi)
New Rate of Interest : 13%
New Term : 24 years (INR 15,451.08)
After 10 years:
Outstanding Balance : 1,304,001.31
Remaining Loan Term : 10 years (actually 19)
Amount available : 439,235.45 (From investment from reduced emi)
New Rate of Interest : 14%
New Term : 24 years (INR 15,451.08)
After 15 years:
Outstanding Balance : 1,262,307.77
Remaining Loan Term
Amount Available : 1,060,071.28
After 16 years
Outstanding Balance : 1,249,889.30
Remaining Loan Term
Amount Available : 1,250,014.20
You can pay all at once. So, although the tenure as per the bank will be around
35years, you have paid the loan in just 16 years.
The problem with this technique is, at some point of time, your loan statement will say, you will be in debt for 35 years. So, the bank may not cooperate well with you.
Use this only if the expected % from the market is much higher than that of the interest rate.
Strategy 3:
You can also mix and match both these two techniques, in such a way that you can arrive at a best combination at any point of time.
Loan amount : 15,00,000.00
Tenure : 20 years
5 years fixed
Rate of Interest : 11%
EMI : 15,482.83
After 5 years:
Outstanding Balance : 13,62,209.01
Remaining Loan Term : 15 years
New Rate of Interest : 13%
Amount that can be prepaid : 140,441.53 (From investment from reduced emi)
Outstanding Balance : 12,21,767.48
New EMI : 15,458.32
After 10 years:
Outstanding Balance : 1,035,311.82
Remaining Loan Term : 10 years
New Rate of Interest : 14%
Amount that can be prepaid : 142,650.39 (From investment from reduced emi)
Outstanding Balance : 892661.43
New EMI : 13,860.04(Amount that can be saved: 3188.91)
or
New Term for same EMI : 8 (EMI = 15,506.87)
Choosing same Term:
After 15 years:
Outstanding Balance : 595,662.99
Remaining Loan Term : 3 years
New Rate of Interest : 14.5%
Amount that can be prepaid : 285,986.84 (From investment from reduced emi)
Outstanding Balance : 315417.66
New EMI : 10,856.98
or
New Term for same EMI : 2 (EMI = 15,218.72)
After 17years:
Investment value : 51,494.32
You can prepay the loan in 17 years, and you will have a mutual fund investment value of 51,494.32
In all these techniques, I haven't considered the tax savings. If you included the amount of tax saved also, you will be able to handle the interest rate hikes, better, and also, you will be able to prepay the loan much faster, or even create greater wealth.
Points to consider while considering the tax benefits:
The more tax you save, better it is. As we are investing the same amount, whether it is principal repayment or as interest, the total out flow is the same. Hence higher savings in tax should be preferable. So, always restructure the EMI in such a way that you will get higher tax benefits.
In such a case, the strategy 2 will prove to be very efficient than others. Because, in this strategy, we pay interest of more than 1.5 lakhs for around 15 years, which by itself gives around Rs 50,000/ Investing this in mutual funds, will generate a return much higher that you will be able to prepay the loan within 13 years.
If the property you buy is to let out, then you will not have the 1.5 lakhs cap for interest payment, there by producing a better returns.
Conclusion:
Use equities for long term wealth creation. Use leveraging appropriately. Although this works well with home loans, you should not apply the same technique with personal loans as the interest rate is 16%, but our expected earnings in stocks is just 15%. Also, don't be greedy, don't expect 30% return from the market. Market always surprises you.
If you can invest much higher, you
posted by Jayaprabhakar | 7:13 AM
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