How Does Partial Prepayment of a Home Loan Work: Understanding the Simplified EMI Process

When managing a home loan, one of the key questions many borrowers have is whether and how prepaying part of the loan can work in their favor. In this article, we will explore how partial prepayment works and the impact it has on the monthly payments (EMI), particularly focusing on the interest dynamics and benefits for the borrower.

Understanding EMI

Let's start by defining the key terms involved in a home loan.

Loan Details

Loan Amount: Rs. 300,000
Loan Term: 10 years
Interest Rate: 9%
Monthly EMI: Rs. 3800
Total Interest Payable: Rs. 156,033
Total Amount Payable: Rs. 456,033

EMI Breakdown

Here is how the EMI is broken down:

At the end of the first month, the loan account would show Rs. 300,000 plus one month's interest at 9%, totaling Rs. 302,250. Once the EMI is remitted, the account will show minus Rs. 3,800, or Rs. 298,450. For the following month, the interest will be charged on the new principal amount of Rs. 298,450.

As seen in the above breakdown, each EMI is divided into interest and principal portions. This dynamic adjustment ensures that the outstanding principal reduces over time.

How Does Part Prepayment Work?

Part prepayment is a common method many borrowers use to reduce the overall burden of the loan. However, it is important to understand the mechanics behind it.

Interest Rate and Flexibility

The benefits of prepayment are most advantageous when the current EMI is not causing any difficulty and the borrower is still at a relatively young age. Here’s why:

If you can easily afford the current EMI and have a good loan term ahead, you might consider reducing the EMI and extending the tenure. The difference can be invested in a monthly RD (Recurring Deposit) account, providing further liquidity. This accumulated amount can be used later, especially if there is an upward revision in the EMI. The funds can help in paying off part of the loan, keeping your scheduled repayment intact. Alternatively, if the borrower’s age is not favorable, it is better to reduce the loan tenure. This approach allows the borrower to get accustomed to a certain repayment framework and ensures that the regular EMIs are covered.

Interest and Returns

When making a prepayment, the bank adjusts the remaining interest charges. For instance, if part of the loan is prepaid, the interest is recalculated for the remaining portion. If the funds are parked in a fixed deposit account, the interest earned will be at a slightly lower rate (around 6.5%) compared to the loan interest (around 9%). This difference is minimal if the borrower is not in the tax bracket for income tax.

Impact of Payment Date

The EMI is calculated with specific assumptions, and the actual payment date can impact the number of EMIs paid. For instance:

If the stipulated payment date is the 15th of every month but the payment is made on the 5th, the borrower might pay 118 EMIs instead of the scheduled 120 within a year. Conversely, if the payment is made on the 25th, it might end up as 122 EMIs. These variations can occur due to the monthly calculation vs. daily calculation of interest, and the impact of a leap year, where an additional day affects the interest.

Final Considerations

Once the prepayment is remitted, it cannot be taken back. Thus, careful planning is crucial before making any prepayment. It is also vital to consider the cost and benefits, including interest savings and liquidity.

For detailed planning and to ensure that the prepayment is handled correctly, it is advisable to consult with a financial advisor or the bank servicing the loan.