Use FD funds to prepay floating loans

RBI tightened monetary policy by increasing repo rate by 50 bps to 9%. The cash reserve ratio has been increased by 25 bps to 9%. This move of RBI has pushed up interest rates across the board which is haunting the borrowers.

Therefore in case home loan rates rise, it is going to create a big hollow in the borrowers’ disposable income, which is already hit by inflation. While bond profits on 10-year government bonds rose to a high of 9.40%. In spite of rise in profits bank deposits to show negative returns after regulating for inflation.

In such a situation it would not be advisable to keep the money in bank deposits, when you have to pay high interest rate on a housing loan.

For instance you have taken a loan for your new home two years ago. As of now, you have a loan outstanding of Rs 20, 00,000 and the prevailing rate of interest is 12.25%, which is payable over the 20-year term of the loan. The EMI works out to Rs 22,371.

You also have an FD which has got matured and you will have a cashflow of Rs 1, 00, 000, keeping aside the accumulated interest. In case you have made an FD for one year at 9.75% you will make around Rs 10,000 one year.

In spite the higher rate of interest it is advisable to prepay your loan. In case bank do not charge penalty for early payment then prepayment can beat off almost 41 EMIs at one go, and this will bring down the loan payment tenure to 16 years and 7 months from 20 years. Like this you will save Rs 8,18,322

In the initial years of your loan, the EMI has higher interest component. Even though you pay 1% prepayment penalty, you will be paying off around 38 EMIs. That means, the tenure is reduced to 16 years 10 months and you do not pay Rs 7,59,922 in interest.

Now if you choose to use FD earning around Rs 10,000 at the end of one year, you will be paying Rs 2,43,637. Hence prepayment is a clear winner. Now the question arise does it make sense, to opt for a premature withdrawal of the fixed deposit with a bank? Yes, by all means.

The savings in interest payable are far more than the opportunity lost on FD interest. But you have to be quick in taking decision, because if your bank is faster than you in increasing the rate of interest, the benefits you can get out of prepayment will be moderate.

In case, when the bank increases the rate of interest to 12.75%, then what impact it has on your Rs 20,00,000 loan. For 20 years, the new EMI will work out at Rs 23,076 and if you chose to keep the amount of EMI constant at Rs 22,371, the tenure will extend to 24 years.

Also, if you plan to prepay after the rate hike, the benefit will be moderate due to high interest rates.

In fact, a segment of borrowers, who have raised fixed-rate housing loans when rates were low, can be in better off not prepaying. This segment includes those who are getting a higher rate on FDs than the fixed rate that they pay on home loans.

Another inducement not to prepay the loan will be to enjoy the deduction to maximum possible (Rs 1, 50,000). In such cases one must be flexible and keep a check on the loan outstanding and the interest component. Traditional knowledge, though, recommends a debt-free status.