Ponder before pre-paying

While prepaying of home loans to banks is catching on, it has to be a carefully considered decision with future financial security and comfort being the key guiding factor

While the banking regulator, Reserve Bank of India (RBI), has given clear-cut instructions to all the banks not to charge any  prepayment penalty on home loans, making the practice of  prepayment more lucrative than ever before in the past, there are many private sector banks, which continue to  charge prepayment penalty upto 4 per cent of the value of the outstanding home loans.

Action points for improving customer protection had been recommended by an annual banking ombudsman conference, held in Mumbai on January 30, which was  attended by the RBI governor, Dr Raghuram G Rajan. The conference had recommended that the bankers’ body, Indian Banks’ Association (IBA), may issue instructions at the earliest to all banks to discontinue levy of prepayment penalty on all floating rate loans.

Usually it has been seen that those people go for foreclosure of home loans who have received lump-sum payments in forms like maturity of provident fund or  post-retirement benefits and in many cases unexpected money resulting in windfall gains or sudden profits from business.

Bankers feel that the practice of prepayment may be beneficial for individuals. But the same may not hold  good for banks as banks’ cost of fund is hit by taking over the asset with comparatively less rate of interest.

Advertisement

Says M Narendra, chairman and managing director, Indian Overseas Bank: “It is important to assess how to  take care of future requirements before deciding to go for  foreclosure of the home loan. Two things must be kept in mind while resorting to the practice. First, you find out if  it is the right time for you to go for the same. Here, I mean, one must be cocksure of having completely extra surplus amount to do the job. Secondly, you must finalise whether it will serve your financial requirements for the short-term or the medium term. Frankly speaking, it is the most important to know that your monthly home budget in future should not get affected at all while doing so.”

Go for the prepayment when interest rates are LOW
By Dr Prashant Das
A Traditional housing loan starts as a lump-sum principal payment from the lender to the borrower, after adjusting for financing costs. The loan principal is then amortised over the loan term (say 20 years). During the term, the borrower makes frequent (usually monthly) payments to the bank. Of this payment, a portion is attributed to principal repayment and the rest to interest payment. Since a portion of the principal owed dies away with each payment, the process is called amortisation (derives from ‘mortality’). During initial years, the outstanding amount (loan balance) is higher since less of the principal component is paid-off until then. Clearly, the borrower is liable to a larger portion paid towards interest during initial years. After each payment, one can calculate how much of the principal component is still outstanding. Rather than paying this outstanding balance over several remaining payments, a borrower may choose to instantly pay a much larger principal amount as a lump-sum payment. This event is called pre-payment.
Conventional wisdom may suggest that when we lend our money to a borrower, we should expect it to be returned sooner than later. Bankers may have a slightly different take on it (i.e. the later the better). The reasoning is simple: they like to maintain a stream of ‘interest’ payments over multiple payments. After all, the principal component is their own money being returned and it is the interest component where they could potentially make a profit. The event of prepayment curbs this profit generating potential. As a result, several mortgage contracts may come with ‘prepayment penalty’.
Loan prepayments could be due to many reasons: selling the property, moving to a different market and so on. From a borrower’s standpoint however, the prepayment could also be a strategic financial decision. Loan interest rates are often not very responsive to dynamically changing market interest rates (this is true also for floating rate mortgages)where caps and floors to interest rates may be applied to restrain interest rate responsiveness). Most real estate loan contracts are very long term in nature. Thus, a prepayment decision may make sense when the market interest rates have fallen substantially compared to the original loan contract. Why should one continue paying a higher interest rate on her mortgage if the market rates have fallen? Several prepayments are immediately followed by loan modification (to a lowe r interest rate) or balance transfer in the pursuit of reducing the borrowing costs. The catch lies in initial financing costs and prepayment penalties. The amount of the original financing costs, early prepayments and p re payment penal tie s increase the effective borrowing ‘costs’ of a mortgage loan. Decrease in the interest rate is the ‘benefit’. One has to weigh the costs versus the benefits of prepayments which require an understanding of mortgage mathematics •
(Dr Prashant Das is an Assistant Professor (Real Estate Finance), Ecole Hoteliere de Lausanne, Switzerland. Dr Das has co-authored “Real Estate Finance in India”, India’s first book in this area published by Sage Publications in 20 14)

It is a well known fact that the average life for repayment of a home loan is less than half of the maximum repayment period as permitted by the lender as part of contract which is reached between the lender and the borrower at the time of finalisation of the loan. Still, people prefer to clear their outstanding within minimum possible time.

HS Gill, executive director, Hudec, says: “The average life for repayment of a home loan is 1 5-20 years. However, it has been observed that in a number of cases, the borrower wants to clear their home loans in a standard repayment period, spanning not more than seven years and hence the trend of pre-payment of home loan has picked up in the country. As per a time-tested tradition that has been in practice in the country from eons, nobody wants to retire as a borrower. Also, one has a yearning to be free from all kinds of liabilities when one crosses the age of 60 years. However, one should go for prepayment of home loan only when one is comfortable enough in prepaying so.”

You must finalise whether it will serve your financial requirements for the short-term or the medium term. Frankly speaking, it is the most important to know that your monthly home budget in future should not get affected at all while doing so.
M Narendra, CMD, Indian Overseas Bank

However, bankers strictly advise borrowers they should think of foreclosure on certain conditions only and for this they can have a checklist so as to avoid any untoward incident in future.

Says an executive director of a PSU bank, “Prepayment of home loan is advisable only in case the borrower’s repayment capacity has increased all of a sudden due to some reason or the other. However, they must see that  they are getting the benefit of lower rate of interest from the new lender so as to make their process of shifting from  one bank to another meaningful one. Again, if one is able to go in for foreclosure, it also means that he is no longer a poor fellow and hence he may be deprived of various government-run schemes meant for poor.”

Nobody wants to retire as a borrower. Also, one has a yearning to be free from all kinds of liabilities when one crosses the age of 60 years. However, one should go for prepayment of home loan only when one is comfortable enough in prepaying so.
HS Gill, ED, Hudco.

A senior banker, requesting anonymity, said that prepayment normally happens in cases where either banking charges like processing fee is less at the new bank  or the borrower has enough liquidity, either due to sale of his ancestral property or sudden boom in his business. However, one must be assured that one is comfortable  enough to meet his financial needs in future, like marriage of his daughter or any other big expenses before opting for foreclosure of his home loan, the banker adds.

However, a few bankers have contrasting views on the issue. R Koteswaran, executive director, Bank of India, says: “I would advise the borrowers that rather than shifting their home loan from one bank to another, they should  better remain stuck to the same bank from where they  had taken the loan originally. The simple reason behind it being the fact that you are not only familiar with the working of the particular bank, but also often the staffs do extend you tremendous support there. Going to the  new bank will make the job of the repayment of your loan a difficult one. Hence, it is always better to remain wit the same bank.”

Going to the new bank will make the job of the repayment of your loan a difficult one. Hence, it is always better to remain with the same bank.
R Koteswaran, ED, Bank of India

Advertisement

Advertisements