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When a common Indian citizen takes a 20 or 25 year home loan from a bank to buy his own house, he feels that he is gradually becoming the owner of his house by paying a small installment every month. But very few people understand the bitter financial truth hidden behind this long period. In the initial period of the loan (first 7 to 10 years), 70 to 80 percent of your monthly installment (EMI) goes towards paying only the interest of the bank, while there is a very nominal reduction in the principal amount. In a 20 year loan, on an average a borrower returns more than his principal amount to the bank only in the form of interest. For example, if you take a home loan of Rs 50 lakh at an interest rate of 8.5% to 9%, you will pay only interest of around Rs 55 to 60 lakh in 20 years. That means for a house worth Rs 50 lakh, a total of more than Rs 1.10 crore goes out of your pocket.
One of the simplest, practical and effective strategies recommended by financial experts is to pay ‘1 extra EMI every year’. Usually there are 12 months in a year and you pay 12 installments. Under this formula, you have to pay 13 installments instead of 12 in a year. That is, in any one month of the year—be it Diwali bonus, March incentive or a tax refund—a lump sum amount equal to your regular EMI has to be deposited in the bank as ‘Principal Prepayment’. When you pay this additional installment, the bank cannot deduct any interest on it; This entire amount is directly deducted from your outstanding principal. As soon as the principal amount decreases, the compounding interest charged from the next month immediately reduces, due to which the repayment timeline of your loan starts shrinking rapidly.
Let us understand this with absolutely accurate and real data. Suppose you have taken a home loan of Rs 50 lakh for 20 years (240 months) at an annual interest rate of 8.50%. In normal circumstances your monthly EMI comes to Rs 43,391. In 20 years you will pay a total of Rs 1,04,13,879, of which Rs 54,13,879 will be only interest. Now if you start depositing just one additional EMI (Rs 43,391) towards the principal every year, your loan of 240 months reduces to about 158 to 160 months (approximately 13 years). This simply means that your loan will expire approximately 7 years before the scheduled date. Not only this, with this one small habit you can save more than Rs 18 to 20 lakh in interest on your hard-earned money throughout your life.
If you are going to adopt this strategy, it is very important to understand the rules of the bank. First of all, as per the clear guidelines of the Reserve Bank of India (RBI), no bank or housing finance company (HFC) can charge pre-payment penalty on a home loan with floating interest rate. Therefore you will not have to pay any penalty on depositing additional amount. Another important point is that whenever you deposit additional installment in the bank, clearly instruct in netbanking or in the bank branch that this amount should be adjusted as “Principal Repayment” and not as Advance EMI. The third and most important decision is that after pre-payment, the bank asks you two options: ‘Reduce EMI’ or ‘Reduce loan tenure’. You should always opt for reducing the loan tenure, as the biggest interest savings come by reducing the tenure.
For salaried professionals, withdrawing 1 additional installment every year is not a very difficult task. You can directly transfer a small saving from annual appraisal, performance bonus or tax saving returns received every financial year to the home loan account. If you don’t have the money for a full EMI in a year, you can also top-up your EMI by 5% or 10% every month; Its effect is also exactly the same. Instead of living with the mental stress of EMIs for 20 years, this disciplined financial approach can help you become completely debt free at the peak of your career. Providing a secure, debt-free roof over your family is the first step to true financial freedom.