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Thursday, August 16, 2012

How to decide whether to Pre-Pay your Home Loan

What is a Home Loan
A home loan is a useful financial vehicle that gives birth to many a middle class dream. Home loans are one of the biggest commitments from common man’s perspective. With long tenures these loans, sometimes outlive the individual.

What is prepayment of Home Loan
There is one option through which an individual can bade adieu to his loan and become the complete owner of his/her house. Loan prepayment is an option where the person pays a sum higher than his regular installments to reduce the principal amount of his loan. If the prepayment amount is high enough it can also reduce the tenure of the loan.

Should i pre-pay my home loan or not?
Well, this seems to be confusing a lot of my friends...more than what i expected. Any such decision regarding pre-payment of home loan would depend on a simple Return On Investment (ROI) Analysis. (To know more about ROI, please refer to the post :Do you know your Return on Investment (ROI) )

To put in simple money terms, if you have an amount X available with you which you want to use for loan pre-payment, you must consider this as a simple investment decision. You need to look at all investment options which can maximize the return on this X amount over a defined period of time,  and one of the additional options you should consider now is "Loan Pre-payment"

Options to consider before taking a decision
Lets consider some of these options as an example

Option 1 : Pre-pay the current home loan
If you go for this option, you need to calculate how much money do you save on principal+interest by prepayment. So, if you pay X amount as prepayment, then depending upon the interest rate that your bank is charging, what is the interest (lets assume Y1 amount) that you will save till the end of the loan tenure (lets assume this to be 10 years). Lets assume that you arrive at a figure of a total of say Z1 (where Z1=X+Y1) So, this is option 1 where you invest X amount today and get back (or save) Z1 after 10 years. So, Z1 becomes your return in  Option 1 after 10 years.

Option 2: Invest amount X in equity or debt funds
If you have been calculating your ROI through each mode of investment over the past few years, and lets say you can get an average 12% annualized returns on your equity investments (Stocks, MFs etc), then in that case, X amount invested for 10 years @ 12% compounded rate yields an amount Z2. So, Z2 becomes your return in Option 2

Option 3 : Invest in another Real Estate
This is another option that people look at. Instead of prepaying the current home loan, people tend to invest in new real estate property. Again, depending the likely returns on real estate in the specific location where you are investing, you would need to get a reasonable idea for the likely returns and arrive at an amount Z3, which would be the market value of the real estate investment after 10 years. In India, the chances are that those would still be higher than the returns that you are getting through Option 1.

Depending on what gives you the max returns out of Z1, Z2 or Z3, you can take an informed decision. 

The book "From Rat Race to Financial Freedom" gives details on how to invest in real estate and at what stage of your financial freedom life cycle.

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Manoj Arora

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