Applying for a loan allows you to meet urgent expenses and make significant payments without overburdening your finances. For instance, a home loan from a bank or a reputed NBFC lets you purchase a new house while shouldering just 10-40% of the total payment burden as a downpayment. You can repay the home loan in equated monthly instalments (EMIs) and opt for a tenure that significantly eases the burden.
Similarly, you can purchase big-ticket items from an online2 marketplace or offline stores and repay the amount in EMIs. From student loans to personal loans, we apply for loans to make our lives easier and effectively address certain financial obligations or requirements. Banks and non-banking financial institutions provide loans at interest rates that can range from 6% to over 20% depending on several factors, such as your CIBIL score and loan purpose.
By using EMI calculators and opting for prepayment, you can maximise your savings and significantly reduce the amount you repay to the institution.
What is prepayment
When you apply for a loan (for the sake of our discussion, let us consider a home loan), you agree with the lending institution to make EMI payments over several months. The tenure for home loans can range from 12 months (1 year) to 240 months (20 years), or even more in some cases. Hence, you must make EMI payments over the agreed-upon period. Your EMI will comprise two components—the principal (loan amount) and the interest.
When you apply for a loan with a long tenure, you pay a significant amount as interest over the loan period. You must use a home loan EMI calculator to ensure you strike the right balance between EMIs and tenure. This helps you find an EMI amount that doesn’t interfere with your monthly obligations and a tenure that doesn’t warrant a hefty interest amount.
Most lenders also provide you with the option to make prepayments. A prepayment is the additional amount you pay towards your home loan debt, apart from EMIs. This allows you to considerably reduce the total interest you pay towards your home loan and reduce the home loan tenure. If you receive a significant pay raise or a lumpsum amount (say, as inheritance), you can use the corpus to make prepayments and reduce your total home loan debt.
Example
Let us consider an example to understand this better.
- Let us assume you applied for a home loan of Rs. 80 lakh with a tenure of 15 years.
- The interest offered by the lending institution is 8.75% per annum.
- By using any home loan EMI calculator, you can understand that the EMI you must pay over the loan tenure is Rs. 79,956.
- However, you received an inheritance to the tune of Rs. 30 lakh. You wish to make a lump sum prepayment to reduce your EMI and tenure.
- If the tenure remains constant, you only pay Rs. 49,958 as EMI and save Rs. 23.53 lakh over the entire loan period!
- If you wish to reduce the tenure, you can pay the same EMI (Rs. 79,956) and reduce the tenure from 180 months (15 years) to 86 months and save a staggering Rs. 46.48 lakh during this period.
You can use any home loan prepayment calculator to make such calculations.
How does the loan prepayment calculator work
The loan prepayment calculator uses the formula:
Remaining principal = (Remaining principal – Prepayment amount) * (1 + i/n)^(n*t)
Where:
The remaining principal is the principal amount you must pay after making the prepayment.
‘i’ is the interest per annum on the home loan.
‘n’ is the number of times interest is added annually (for monthly compounding, ‘n’ is 12).
‘t’ signifies the leftover term of the loan (in years).
Benefits of using a home loan prepayment calculator
The following are some of the main benefits of making prepayments and using EMI calculators:
- Maximising savings: By using loan prepayment calculators, you can figure out the total interest you will save over the tenure period.
- Finding reduced tenures: You can understand how much you can shorten the tenure period after making the additional payments by using the loan prepayment calculator.
- Identifying EMI changes: You can also calculate the adjusted EMI amount after making prepayments, which will help you plan your finances better.
- Optimising prepayment strategies: Depending on your limitations and financial goals, you can find the best prepayment strategy by using these calculators.
- Knowing different scenarios: You can input various prepayment amounts and check the EMI and tenure. You can then compare the different permutations and identify the ideal prepayment-EMI-tenure combination.
Conclusion
Prepayment allows you to reduce the EMI or tenure of the loan while significantly reducing the total interest you pay to the lending institution. By using EMI calculators and loan prepayment calculators, you can effectively strategise your loan repayment. This allows you to make better financial decisions and maximise your savings.
