Home loan borrowers make this common mistake. For a Rs. 50 Lakh home loan payable over 20 years at 8% interest, the EMI is Rs. 41,822. As is well known, much of the EMI initially is interest.
It is incorrect to sum the total interest paid (Rs. 50,37,281 in this case) and claim that as a “loss” and rush to prepay the home loan as soon as possible. The interest is paid to the bank over several years, and one cannot sum up the interest because the time value of money has to be considered.
First of all, it is not a loss to pay interest to the bank. We did not have Rs. 50 lakh upfront, and the bank lent it to us. They need to be compensated for this. They do not seek this compensation immediately, which is fair to the borrower and the lender (the interest paid increases with duration).
Secondly, if we consider the interest as a “loss”, it is incorrect to perform a simple sum over time. If we factor in the time value of money, the “loss” will be significantly lower.
Thirdly, rushing and prepaying the home loan could result in a bigger loss, as the money used for prepayment could have been invested at a post-tax interest rate higher than the home loan’s. More importantly, that “extra” money could have been invested for retirement and allowed to grow over the duration of the loan. This time lost is lost forever.
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But when you’re emotional about it (and everything about a home loan purchase is often overtly emotional), then loss is what you say it is and not what the math says. And the math, which is usually not easy, is particularly unappealing here.
To understand the impact of the interest paid over time, you will have to use an idea called Net Present Value (NPV Excel function). The NPV is the value of future cash flow over the lifetime of the loan/investment discounted to the present.
There are several resources about this on the web, or you can ask Perplexity or ChatGPT to compare the NPV of two scenarios: A normal repayment and B, prepayment with a specific schedule. The lower NPV is the better choice (for borrowing).
Usually, if the discount rate or the rate of return (post-tax) expected on the amount kept aside for prepayment is higher than the home loan rate, then normal repayment will be better.
In other words, I pay the EMI and have some spare cash to invest. As the expected rate of return on investment of this spare cash increases, paying off the loan normally becomes more beneficial than pre-paying.
As a thumb rule, if the return you can make (after tax) on spare cash is well above the loan interest rate, prepaying does not make sense.
We will soon release a calculator based on NPV to compare the two scenarios of normal vs prepayment. However, emotions often dominate decisions.
Which is why we have always recommended a balanced approach between prepaying and investing.
Our investments will definitely suffer when we begin paying EMI. However, it should not go to zero. Whenever you receive extra cash from pay appraisals, promotions, or other sources, consider increasing your investment slightly and prepaying your home loan.
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