Why Prepayment of Housing Loan Does not make sense ?

This will be one of the most technical articles till date let’s make it simpler by taking an example.

Mr.PB age 34 has taken a loan from a leading finance company and is paying an EMI of 24000 and the loan is taken for 20 years. He is overwhelmed by the interest amount that he paid in his third year and he decides to prepay the loan in the forth year.

Let us take a moment here to understand how financial institutions charge us the EMI (Equated Monthly Installment)In the initial years in the EMI contains more principal component than interest.

As time goes by the principal component increases and the interest component decreases

Coming back to the case, the following are the details of Mr.PB’s loan.

Loan Amount: Rs.24 lac

Rate of Interest: 10.5%

Installment / month (EMI): Rs: 24,299

Annual Payment made through EMI = 24299*12 = 291588

Now lets look at is yearly amortization schedule:

[Detail of his payment and its components like interest and principal]

Click on the image to see the schedule properly

Say he makes prepayment in the end of fourth year highlighted above in this case

Principal Paid till date	2,44,106
Principal Outstanding (Prepayment Amount)	22,14,916
Years Remaining	16 = 20 - 4
EMI Saved	46,65,408 = 291588*16

Now presuming that he would have taken a financial advisors advice and instead of prepaying the loan he invests the amount in say an Index Fund (e.g. Index fund currently ranked 15^th by moneycontrol.com) a bulk investment would have yielded 26.85% (Componded)* return. The amount Rs.22.14 lakh invested would have become Rs.9.95 Crore

Principal Invested	22,14,916
Avg rate of return of Index Fund (CAGR)*	26.85%
Years Invested	16
Amount*	9,95,41,643

Mr.PB would have profited Rs.9.5 Crore (99541643 – 4665408) if he would have chosen to invest in a index fund over prepaying

To every rule there is an exception [When it makes sense to prepay]:

· When you are expecting uncertainty in the source of income with which you are making your EMI payment.

· When you are getting a better re financing deal in spite of the pre payment penalty.

· When the loan tenure is less (say two years) the risk is high in markets and there is less compounding.

Having made the case for non prepayment let me tell you that you might be an exception to the rule , let your financial planner decide what’s best for you.

* Notes:

1. We have taken oldest index fund of SBI which is the oldest private fund house; this is just an example and not a recommendation.

2. Index Funds are less risky than Diversified Equity and Sector Funds

3. Compounding Formula used A = P(1+1/R) ^ N where P = amount invested ,R = Rate of Return , N = No of Years.

4. In the above calculations we have not considered the benefit one gets for continuing the housing loan under section 80 C