Tips to Reduce Interest Burden on Home Loans

The biggest expenditure for most individuals is the monthly installment paid towards the loan taken for buying a home. This expense accounts for approximately 30% to 40% of a person's income. This makes it difficult for users to invest towards achieving other financial goals.

Reverse compounding effect

Investments earn higher returns when these are held for a longer period of time because of the compounding effect. Many homebuyers choose longer tenures with the objective of reducing their monthly outflows. However, when an individual takes a loan with a long duration, this phenomenon is reversed. They pay more interest in the longer period. In comparison, when a borrower chooses shorter home loan tenure, the principal repayment occurs quicker. Because interest is calculated on the outstanding principal balance, higher repayment reduces the absolute servicing cost.

Here are two ways to reduce the interest burden on existing property loan

1. Refinancing

Borrowers may consider refinancing the outstanding loan amount to decrease the home loan interest rate. With a lower rate, the monthly installment reduces, which may result in huge savings over a period of time.

Here is an example to understand the benefits of refinancing. As per the home loan EMI calculator, if the interest rate reduces from 10% to 9%, the monthly installment decreases from INR 45,435 to INR 41,960 on a loan of INR 50 lakhs. Over a period of 25 years, the total savings on the interest outgo is approximately INR 10.42 lakhs.

However, while refinancing, users need to consider pre-payment penalty, legal charges, and other fees that may be levied by the original lender. These additional costs may reduce the actual interest savings.

2. Repay principal faster

Repaying the principal amount faster reduces the interest burden on the borrowers. Individuals are advised to pay a higher amount than their regular equated monthly installment (EMI), which will reduce the principal amount and save interest.

Here are three ways to repay the principal faster

Pay an extra EMI

Borrowers may use their annual bonuses to pay an extra EMI over and above the existing installments. Using the above example, if an individual pays an additional EMI of INR 45,435, the home loan is fully repaid in 19 years and 1 month. The interest saved on the balance duration is over INR 62 lakhs.

Increase annual EMI

Most salaried individuals receive an annual increment to their incomes. Borrowers are recommended to increase the EMI on their loans by a certain percentage. This could be based on the increase in the average annual salary. If a borrower increases the EMI by 5% each year, the loan of INR 50 lakhs is repaid in less than 13 years. The home loan interest savings in this example is almost INR 45 lakhs.

Combine both

Borrowers may choose to pay an extra EMI each year as well as increase it by a certain percentage. When both these options are adopted, the entire home loan may be repaid in 11 years and 8 months, which translates into interest savings of roughly INR 39 lakhs.

Reducing the interest burden is beneficial; however, it is important to choose an option that will not result in financial distress. Borrowers must opt for an EMI that they are able to pay without facing liquidity crises. Failing to pay timely installments has severe outcomes and therefore, avoiding this is absolutely crucial.

[Source: http://www.tatacapital.com/blog/home-loan/tips-to-reduce-interest-burden-on-home-loans.htm]