Making part prepayments whenever you have surplus funds helps ease the debt burden. With penalty on prepayments removed this is an ideal option to ponder over. Long tenure loans are more expensive as the cost of borrowing increases with tenure. Shorter tenure loans are less expensive but the EMIs can sometimes become very high.
Kamal has taken a home loan for Rs 50 lakhs. The tenure of the loan is ten years. The rate of interest that the lender charges Kamal is around 11 percent. Let us assume that Kamal gets a windfall. It could be a share in some inherited property or proceeds from some other investment. Kamal has Rs 10 lakhs with him. He has two options. He can either use the lump sum to make a part prepayment on his home loan or invest the money elsewhere.
If Kamal decides to make a partial prepayment and ease his loan burden, what will be his savings on the cost of the loan? As evident in the table, after making a part prepayment his EMI falls considerably. If Kamal makes the part prepayment at the end of the first year, his cost of borrowing will be Rs 26.85 lakhs. Instead, if he makes the part prepayment at the end of the second year, his cost of borrowing will be Rs 27.57 lakhs. The more he delays his prepayment, the greater would be his cost of borrowing. Kamal’s cost of borrowing translates to around Rs 31.46 lakhs if the prepayment is made at the end of the eighth year.
The cost of borrowing is greater when a partial prepayment is made towards the end of the loan tenure.If you make prepayments earlier in the tenure, the cost of borrowing is lesser.Making a part prepayment earlier in the tenure of the loan yields greater cost savings. It is prudent to make part prepayments and clear your debt faster if you have surplus funds.