Prepayment Considerations

1. What is the maximum that can usually be prepaid?
2.  What is the minimum that must be prepaid?
3.  What are the cumulative and non-cumulative prepayment privileges?
4.   Should a prepayment follow amortization schedule?
5.   What about the frequency of prepayment?
6.   When can a mortgage be prepaid?
7.    If prepayment is allowed once a year; who decides the date: borrower or lender?
8.    When does the prepayment privilege begin?
9.    What is the usual penalty when prepaying open portion of the closed mortgage?
10.    What is the usual penalty when prepaying closed portion of closed mortgage?

Usually lenders allow borrowers at their option to prepay up to 10% or 15% annually of the original or currently outstanding balance. If it is based on original amount then it favors borrower.

Is it better to prepay home loan so they often fix a minimum prepayment amount that must be paid in order to utilize the prepayment privilege. Depending upon the lender and amount borrowed, it can be any amount.

Is it better to prepay home loan privilege or usually non-cumulative which means that if borrower is allowed 10% ($10,000) of the borrowed amount ($100,000) annually, but he paid only $8000 in a year, he cannot carry remaining unpaid amount to next year to add to next year’s prepayment limit of $10,000. They cannot prepay $12,000 next year.

Some lenders allow borrowers to make prepayment anytime of the year and some restrict borrowers to follow either the regular mortgage payment schedule or a particular date for prepayment so is it better to prepay home loan. This actually could mean that even if you have all of a sudden some extra cash on hand which you want to prepay to lower your interest cost but lender might have imposed a clause that you either pay it in a particular month or along with the next mortgage payment.

Different lenders allow different number of prepayments that can be made during the year. It can range from one only a year to unlimited number of times a year provided that the maximum allowed amount rule is followed. The more prepayments a borrower can make, the better off the borrower is.

Some lenders restrict that prepayment can only be made on a particular day of the month. This means that even if the mortgage is fully open and borrower sold the house before the prepayment date so is it better to prepay home loan, he cannot pay off his loan until that prepayment date is reached which means he can lose thousands of dollars depending upon how far is it better to prepay home loan date from the date house is sold off.

If only one prepayment a year is allowed it is better that borrower decides that date. If lender controls the date, it can cost tens of thousands of dollars extra.

Is it better to prepay home loan privilege which does not necessarily begin immediately after the money is advanced to borrower? In some cases it can begin after couple of years has elapsed. Borrower must be smart enough to make right judgment. If he thinks that he will have some extra cash shortly after he signs the contract, he should not allow this type of clause or he should get mortgage from other lender or of different terms. If I have even $5000 extra and I have to wait at least a year before I can make my prepayment then I am losing lots of money on paying interest.

Penalty is usually defined in the prepayment clause section of the loan and borrowers should fully understand these clauses before he signs the contract. Mortgage period is usually very long and borrowers may have to move away or he loses his job or some other financial difficulties may arise. It is always a good idea to consider it very carefully what if I have to break the mortgage because of unforeseen issues. If you don’t care for yourself then who will. So Is it better to prepay home loan or not.

{Source: http://mortgagehunt.blogspot.in/2008/06/prepayment-considerations.html}

Is it better to Prepay Home Loan or Invest?

As someone who knows very little about home loans, the popularity of the titular question never fails to surprise me.

When this question was asked again in the face book group, Asan Ideas for Wealth (AIFW), I learnt something new. Here is an account of my understanding. I thank the members of AIFW for their insight.

Sometime back, on Subras request, Is it better to prepay home loan or invest for retirement calculator and realized that unless one wishes to retire early, there is no flaming hurry to pre-close a loan.

First let look at this issue from both angles

Invest and let the loan run its course

1.      After all, salaries will increase and inflation, which is comparable to home loan rate, will slowly, but surely diminish the value of the EMI.

2.      There are more obvious incentives to continue the loan. Even if there is no tax benefit from the principal component, since 80C is maxed out for most, the interest component is eligible for a decent tax deduction. The tax save can make a difference if invested

3.      Since the interest component is high for the first half of the loan duration, it makes sense to let the loan run at least for half the stipulated period and then pre-pay it.

4.      Is it better to prepay home loan due to investing now we will maximize the effect of compounding. What if you cannot build a large enough corpus for retirement or fund other goals?

 Notice that all arguments are mathematical in nature.

Prepay, close out the loan asap and then invest

1.      Why be in debt? Feels like a sword hanging over the neck. I can’t think clearly. My parents are urging me to get out asap.

2.      Why not actually own the home asap and then invest?

3.      What if interest rates increase? I have a high enough emi as it is!

 Is the 3rd argument the only mathematical one?

·         Let us now look at an imaginary but typical scenario.

·         Akash is a 30 year old, married and with a 2 year old daughter.

·         Gross annual income ~ 15.4 Lakhs. Annual growth 10%

·         Monthly expenses ~ Rs. 40,000; Inflation 8%

·         Home loan (self-occupied): 60 Lakhs; Rate: 10%; Tenure 20 year; EMI: Rs. 57,901;

·         Retirement 30 years away

·         Daughter education 16 years away

·         Daughters marriage 23 years away

·         Section 80C limit: 1 Lakh  (home loan principle is assumed to be not part of deduction)

·         Section 24(b) limit (home loan interest deduction): Rs. 1, 50,000

Akash has now obtained a lump sum of Rs. 3 lakh. Should he invest it or use it for pre-paying?

For both scenarios, we assume that

·         Akash invests his salary after accounting for expenses, EMI, 80C deductions, tax. The tax saved from section 24(b) is also invested.

·         Akash continues such investing after the end of the loan up to retirement

·         The investment is assumed to grow each year at the average rate of 10% and when the need arises –daughters education 16 years later; wedding 23 years later – redemptions are made from the same account.

·         Only long term goals are considered.

Which is better? Investing or prepaying?

Have a look and judge for yourselves. I am automating this Excel sheet so that inputs can be varied at will.

If the lump sum was pre-paid, Aksash will fall short of the corpus required for financial independence. Please don’t argue, not by much! Remember the numbers used here are imaginary. Until you punch in your own numbers, you will not know for sure.

Had he invested the lump sum, he would have got a corpus much higher than that required.

Had Akash, postponed the purchased of the house, would have done much better? Perhaps - shall include this option in the calculator to find out.

So which is better?

If we look only at the graph, investing the lump sum is better.

Not because he will fall short of the retirement corpus needed, but because it is not practical to assume that future cash inflows will be used for investing! We cannot be so sure about the future.

When you have money, invest – right now! Do not assume you will invest from your higher salary 5 years later. That may happen may not happen. Investing now, will get time on your side.

 Prepaying is not terrible!

Frequent prepaying makes sense only when the EMI is very large – more than 50% of net take-home pay.  In such a case the person will feel stifled and it makes sense to at least shorten the suffering. So pre-paying in chunks, every few months does have an appeal.

When our salary is accounted for completely by EMI, expenses and taxes, we cannot

·         Refill our emergency fund if it is used!

·         Handle unexpected recurring expenses

So even this suggestion is mathematical and not just governed by emotions. So even the sword above our neck feeling is grounded in math for those with high EMIs!

{Source: https://freefincal.com/prepay-home-loan-or-invest/}