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How does the tenure affect the cost of the loan?

There are two components of a home loan EMI payment , the outstanding principal repayment and the repayment of your interest. For the initial few years of taking a loan, you do not make a substantial payback on your outstanding principal. Instead, your monthly payment services the interest rate component of your loan.

Higher tenure= higher costs

As you progressively make payments over the tenure of the loan your amount of interest component decreases and you start contributing more towards the principal outstanding repayment. So far so good right? But did you know that by increasing the tenure of your loan, you are actually increasing the amount of interest payable too, and in the process increasing the cost of ownership of the house? Therefore, when you reduce the loan tenure, you cut your interest costs and overall cost of purchase too.

Consider an example to understand this:

Anand decides to purchase an apartment for Rs 20 lakhs. He decides to get a home loan of Rs.16 lakh for 20 years at a fixed interest rate of 11%. The down payment he has to bear on the loan will be 20% of the property i.e. Rs.4 lakh. Over the span of 20 years he would end up paying Rs 22 lakh on his interest payments for a loan of Rs.16 lakh. Finally, he would end up paying Rs. 42 lakhs on a property he eyed for Rs. 20 lakhs which is two times the cost of the property.

What you should do when the interest rate on Home loans are lowering?

Before you borrow a home loan, get one thing straight. A longer tenure may seem more plausible to you because of the low EMI burden it offers, but in the bargain, you end up paying much more than you borrow just because you are paying a steep rate of interest. As a borrower, you should therefore strive to pay as much EMI as possible and shorten the tenure of your home loan.

When the interest rates are tapering, your lender may contact you about the option between lowering your EMI or lowering the tenure of your loan. The idea of a smaller monthly outflow as EMI may sound tempting to you, but always opt for the lowering of the tenure of your loan. Banks by themselves generally offer to lower the tenure of your loan, because making an alteration in EMI is far more cumbersome in terms of paperwork - it’s a win-win for both you and your bank.

 

Let us understand this better with another example.

Say you have taken a Rs. 50 lakh loan for a tenure of 20 years at a floating rate of 11%. Your EMI would work out to be around Rs. 51,609. In the second year of your loan, your interest rate falls by 25 basis points or 0.25%, making your effective interest rate 10.75 %.

You have three scenarios you can choose from:

  1. Reduce your EMI by Rs. 848 to Rs.50671 : This would keep your tenure same and you would save approximately Rs. 1 lakh on your interest payments.
  2. Keep your EMI same : If you don’t make any changes on your loan, your effective tenure would decrease which would save you over Rs. 5 lakhs on your interest payments.
  3. Increase your EMI by Rs. 820 to Rs. 52,429 : Increasing your EMI by a small amount during the initial stages of your loan will benefit you two folds. Not only will the tenure of your loan decrease by a few years, you would also save over Rs.9 lakhs on your interest payments.

If paying a little more stretches out your budget, it is advisable to not make any changes on the EMI of your loan since the tenure of your loan will automatically reduce with the reduction in interest rate.