Home Loan Repayment Strategy: Is it Better to Increase the EMI or Tenure?

Vishnu (36) got the shock of his life when he saw his home loan statement.

He took the home loan in April 2022 at 7% p.a. Interest rate, when the rates were at their rock bottom. The original term of loan was 20 years. It means that he would complete his loan when he would be 55 or even earlier by prepaying at regular intervals when he would receive any bonus or his salary would increase.

Now when the interest rates are rising consistently since the last one year or so, the effective interest rate on Vishnu’s home loan has reached 9.25%. In effect to this, the bank has increased the tenure of his loan by 18 more years. It means that, now he has to continue paying his home loan EMI even post retirement- until he reaches 74!! (How should you plan for Repayment of Loans- factors to consider?)

At first, he thought that it was an incorrect figure. There must be some error at the bank’s end. He then reached out to his bank and sought clarification on this issue.

He approached me with a query- how to manage the home loan repayment amidst this rising interest rate and economically uncertain scenario? Would it be wise to prepay the home loan liquidating some of the “low-yielding” investments in his portfolio now or should he increase his EMIs or extend the loan tenure?

Well, Vishnu is not the only one. The increased interest rates look attractive at the time of making deposits, the borrowers are the bothered lot in this scenario, who now are required to pay high rates to the lenders. So, the long duration loans like home loans need to be managed. ( Also read: How prepared are you for your home purchase )

Let us try to address this issue in this article.

The effect of rising repo rate:

The Reserve Bank of India (RBI) has mandated the banks to do external benchmarking of the home loan interest rates, sanctioned after 1st October, 2019. 

The most common external benchmark used by the banks to link the home loan rates is the repo rate. (Read: How External benchmarking Impact Loan rates?)

So, whenever RBI makes a change in the repo rate in its Monetary Policy, the effect of this is seen on your home loan interest rates. In other words, when the Repo rates increase, the home loan interest rates also rise and vice versa.

From 2019, the RBI has continuously decreased the repo rate until May 2022. So, during this period the home loan interest rates decreased too, and of course mouth watering for those who had plans to buy a new home.

But, Since then the RBI has started increasing the repo rate (nearly 250 basis points, as on March, 2023),  to contain the inflationary scenario in the economy. From the bottom of 4% in 2020, now the repo rate has reached to around 6.50%.

The graphic below shows the repo rate movements from 2019 to March 2023:

Consequently, banks have passed the effect of the rising repo rate to the home loan borrowers and the interest rates on their loans have reached 9%+. In case of NBFCs the rates are in the double digits.

Loan Repayment – Increasing EMIs or extending loan tenure: What to choose?

When the interest rates rise, either you have to increase the tenure of your loans or increase the EMI. 

Generally, the default option the banks exercise is to increase the tenure of the home loans. They keep the EMI same as long as it is enough to take care of the interest component, i.e., (outstanding principal* rate)/12.  If the installment fails to cover the interest then the loan EMI is also increased.

Due to this exercise, many home loan borrowers like Vishnu who had taken the loans during 2019- early 2022, were shocked seeing their home loan statement. The 15-20 year loan tenure has reached 50 years or even beyond in some cases.

However, You can also opt for an increase in the loan installment, if you want to keep the loan tenure unchanged.

But, which option would be beneficial for you? We ran some numbers in Vishnu’s case and found that- if he increases the EMI in line with the interest rate and keeps the tenure of the loan the same (20 years), he would pay a total interest of Rs.58.50 Lakhs on a Rs.50 Lakh loan.

On the contrary, if he chooses the default option, i.e., to increase the loan tenure and keep paying the same EMI as before, the total interest on his loan would balloon to a whopping Rs.1.32 crores.   

From the above analysis, it becomes quite clear that increasing the loan tenure would mean a very high interest outgo over the entire term of the loan in comparison to increasing the EMI.

Therefore, it makes more sense to opt for increasing the EMI of your loan rather than going for extending the loan tenure. 

Other options to manage the increasing home loan burden: 

Yes, increasing EMIs rather than extending the loan tenure is beneficial because the interest outgo in the former is much lower as compared to the latter, particularly in the initial years, when the interest component is higher than the principal repaid.

Apart from these, you can look for partial prepayment of the loan at regular intervals, paying additional EMIs, increasing the EMI by a fixed percentage in line with your income increment to reduce the burden of your home loan. (Read: Why you should not Prepay the loans in Job Loss Scenario?)

Prepaying the loan in the initial tenure of 5-10 years will not only help you complete the loan before the term but would help you save on the interest as well. 

By prepaying 5% of the loan principal every year, you can complete your 20-year home loan in just 11 years. Even increasing the EMI by 5% every year, you can reduce the loan tenure by 5 years.

If the interest rate on your loan is extremely high, say, around 10%+, you can also consider prepaying the loan by liquidating the debt investments in your portfolio as well, due to the spread between the loan interest and the return on the investment being 3% or more. (But since Debt Mutual funds has now lost the tax efficiency post 01.04.2023, so you have to evaluate the options as redemption will result in losing the long term indexation benefit of old investments)

If these options do not work for you, you can try negotiating the interest rate with your existing lender or a home loan balance transfer to another bank offering a lower interest rate.

Look at the bigger picture, then decide:

High Interest rates are the Result of High Inflation, which must be impacting the other areas of personal finances too, so deciding just by considering the interest savings may not be reasonable.. You should look at your overall financial profile holistically to decide whether to go for an increased EMI, extended loan tenure or opting for the prepayment of loan.

Yes, prepaying the loan would do wonders for you. If you can prepay your loan without compromising on your goals and lifestyle then nothing like it. However, it is important to consider:

• Impact of the decision on your existing and future cash flows.
• Any other high interest loan like- personal loan that needs to be cleared first.
• Adequate emergency fund, health and term life cover in place.
• Impact on the  long and short term financial goals and strategy to manage the same?
• Priority (e.g., retirement, kids education) vs. discretionary goals.
• Near term job/income scenario.   

In short, you should have your financial plan prepared considering all the what-if scenarios and decide accordingly which option would be suitable for you to manage your home loan repayments in a rising interest rate environment.

Also, before  prepaying your home loan, do consider the factors mentioned in this article.

Lastly, it is also important to take into account the processing fees (If any), other charges and the terms and conditions associated with prepayment, negotiation and balance transfer of the loan before making the decision.

Bottom line:

Home loan is a long term commitment. Not having a financial plan in place to manage the loan repayments will not only hamper your cash flows but also adversely impact your near as well as long-term financial goals, especially when the interest rates are rising.

Decision whether to increase the home loan EMI, extend the tenure or prepayment of the loan should not be taken in isolation but taking a comprehensive look at your financial life and assessing the impacts of the same.

If things look overwhelming to you, do not hesitate to take the help of a professional financial planner with debt management and overall financial planning.

This article on Home Loan Repayment Strategy is Written by Mr. Varun Baid, CFP Professional