Home loan-Which is the best time to prepay the home loan in 2023?

Which is the best time to prepay the home loan? Is it during the first few years of the loan term? Is it wiser to invest somewhere instead of paying off the loan? Are we really saving home loan interest by prepaying? Let us try to answer these questions by taking a simple example.

Many of us have home loans and due to the recent rise in inflation and interest rates, most of the borrowers are wondering or in a dilemma whether to prepay the home loan or not.

Which is the best time to prepay the home loan?

I know many of you will already have a ready-made answer to the question whether it is valid to prepay if the loan is fresh. However, what is the opportunity cost of not paying off the home loan and investing elsewhere? Is it equal to or less than the home loan rate?

The purpose of this post is to highlight this opportunity cost. This means if instead of prepaying the home loan, you invest in lump sum, what should be your ideal break up?

Many people randomly assume that if the home loan interest rate is 8% and if they prepay the outstanding, they will save about 8% upfront interest payment on the outstanding loan principal. However, this is a complete myth.

This is mainly because in the home loan EMI, your interest portion is usually higher during the first few years, and will come down considerably later. So, when you plan to prepay the principal, how many years are left and the total interest you have to pay during the loan tenure also matters.

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For our example, assume the home loan amount is Rs. 1,00,00,000, the rate of interest is 8% and the term is 20 years. The EMI will be Rs 83,644. The total interest paid by you during the entire period of 20 years is Rs.1,00,74,561. If we combine both the principal and interest, then in total you will have to pay Rs 2,00,74,561.

To understand what is the opportunity cost of prepaying the home loan and which is less stressful, let us break down the entire tenure into each of the loan tenures of 5 years.

You see that during the first five years, you paid around 37% of the total interest (Rs 1,00,74,561) and you paid around 12% of the principal amount.

Hence the balance payable is Rs. 87,52,558 (Principal) + Rs. 63,03,362 (Interest) = Rs. 1,50,55,920.

Now let’s assume that after 5th year you have Rs 87,52,558 in your kitty and you want to repay the loan. So obviously the savings for you is the interest part of Rs 63,03,362.

What amount of Rs 87,52,558 will have to be generated in the next 15 years to compensate Rs 63,03,362? That’s about 3.7% not the 8% many people save!!

Similarly, if you want to prepay after the end of 10th year, you need to consider these numbers.

You see that by the 10th year, you paid around 69% of the total interest (Rs 1,00,74,561) and around 31% of the principal.

So the outstanding amount payable after 10th year is Rs.68,94,062 (Principal) + Rs.31,43,217 (Interest) = Rs.1,00,37,279

Now let’s assume that after 10th year you have Rs 68,94,062 in your pocket and you want to repay the loan. So clearly for you, the savings is the interest part of Rs 31,43,217.

How much will this amount of Rs 68,94,062 have to be generated in the next 10 years to offset Rs 31,43,217? This is approx 3.82% and not 8% savings like the common belief of many people!!

What if you want to prepay the loan after 15th year? Below is the status of the loan after completion of 15 years.

You see that during 11th to 15th year you paid almost 91% of the total interest (Rs 1,00,74,561) and 58% of the principal amount.

Then the balance payable will be Rs. 41,25,190 (Principal) + Rs. 8,93,448 = Rs. is 50,18,639

Now let’s assume that after 15th year you have Rs 50,18,639 in your pocket and you want to repay the loan. So clearly the savings for you is the interest part of Rs 8,93,448.

How much will this amount of Rs 50,18,639 have to be generated in the next 5 years to compensate Rs 8,93,448? This is just around 4% instead of the common perception of many as 8% savings!!

Another way to prove it is that paying off the home loan during the first few years has a far better and less stressful opportunity cost than postponing your home loan repayment to the latest tranche of the home loan.