Prepayment and Refinancing as tools to reduce the increasing EMI’s


Has the Interest Rate caught you off guard and you are in a situation where you don’t see a way to cope with the rising EMI’s of floating home loan rates? Had you known about the steep rise in interest rates in advance, you would have managed your finances in a better way, but what can you do if you are trapped midway?

There is still some light at the end of this tunnel to mitigate the adverse impact of the rising interest rates. Prepayment and Refinancing could be the arsenal which you may use as per your convenience.

You can take the rising EMI’s head on by way of prepayment if you have good surplus at your disposal. Even if you don’t have good balances, you may use the refinancing option with relatively lower fund.

In this article, we’ll explain you about how to go about choosing the right course:-

Prepayment of Loans

While experts say that partial prepayment is always a good option to reduce your obligation, it makes more sense if there is a sharp rise in the interest rates. The higher the outstanding principal of your loan, the more severely you would be hit by the rising interest rate hikes.

A partial prepayment works as an immediate cure which instantly reduces the outstanding principal of your loan, thus reducing the total interest outflow.

Any prepayment shall come from your own saving and not by way of further borrowing. While servicing your loan, if you’ve been able to accumulate some surplus savings or windfall gains like bonus, incentives, surplus, and dividends and so on, you may very well use these as the partial prepayment amount.

If you have deposits which earn less post tax interest, then the cost after calculating the post tax benefit of your home loan, then you are paying a higher cost for the home loan as compared to what you are earning on your deposits.

For eg: – If the Home Loan interest rates have gone up to 11.50% p.a. and after deducting the Tax benefit, the cost comes down to 10.50% whereas if you have fixed deposits which are earning 9% and the post tax returns come down to 8.5%, then you are losing everyday due to the 2% difference between what you pay and what you get  for you to use such funds for partial prepayment of your loans.


How Prepayment of Loan saves Money

For a Loan amount of 2,000,000 at 10% p.a. interest rate for 20 years with EMI of 19,300, when you face an Interest Rate hike of 2%, the following table shows that the benefit of prepayment (if you pay 20% of the outstanding) is highest at the earlier stage of prepayment.

Years Repaid Principal Outstanding Prepayment Amount* Reduced Tenure (Months) ** Saving **
4 1,845,339 369,068 46.49 897,257
10 1,460,486 292,097 26.55 512,415
16 760,981 152,196 9.91 191,263

* 20% Principal Outstanding, ** When you continue to pay original EMI of 19300 after 20% prepayment, *** Reduced Months multiplied by EMI (19,300) as these are the EMI’s you won’t need to pay

Refinancing of Loans

In the deregulated interest rate environment in which we live, there always exists a difference in lending interest rates among the various lenders. Find out the lenders which are offering the lowest rates. You may do so by contacting the Customer Service of Various Lenders.

Compare the interest rate you are servicing with the rates offered by other lenders, and select the lender which is offering the loan at a significantly lower rate and whose terms and conditions suits you the best.

While you can do away with the penalty in the case of partial prepayment, some banks do not allow refinance (balance transfer) without penalty. So, you need to find out from your existing lender about the foreclosure charge they levy in case of a balance transfer.

As you would be getting a loan from a new lender which will pay out the outstanding principal amount to your existing lender, you need to find out all the charges like processing charges, legal fee, stamp duty and so on which the new lender will charge you. Also, look at the terms and conditions of the loan along with other aspects like quality of service with the new lender.

As you have found the lender who is offering you the loan at a lesser interest rate, you need to compute the total interest which is being saved from the refinancing option and then deduct all the charges you would incur during this transfer. If you find the refinancing option to be appealing enough, you can proceed with the refinancing option.

Since, the new lender would only be financing the principal outstanding amount, so you would have to bear all the charges during this balance transfer. So you would need to check if you have necessary funds for paying the foreclosure charges of the existing lender and processing and other fees of the new lender. You might have to use your surplus savings and deposits to arrange money from these charges.

So it depends upon your specific situation as to which option you would like to go for. If you have a good amount of surplus savings, prepayment will work the best for you and if you are little short of good surplus, then you may opt for refinancing your home loan. However, do remember that refinancing could prove to be cumbersome as you would need to go through the entire home loan process once again with the new lender.

How Refinancing of Loan saves Money

Considering a Loan of 2,000,000 at 10% p.a. interest rate and assuming a hike of 2% (to 12%), the following table shows that the Net benefit of refinancing at 1% lower rate (ie at 11%) is greater at early stages of the Loan Service

Years of Repayment Outstanding Principal Total Interest Saving * Refinancing Cost ** Net Gain or Loss ***
4 1,845,339 229,383 46,133 183,190
10 1,460,486 100,264 36,512 63,750
16 760,981 17,836 19,025 -1,189

* When the Interest Rate reaches from 15% to 10% and if you get refinance at 11%, it is total saving in interest outflow, ** Prepayment Charges at 2%and processing fee at 0.5% of principal outstanding, *** After deducting Prepayment Penalty and refinance charges from saving from extra interest outflow due to refinance at lower rate

Karan is CA by Qualification with the rare distinction of being awarded All India Rank 22. He is also the founder of this website and loves to help people with their Tax Queries.