Tenure, FOIR and the Prepay-or-Invest Decision
A 52-year-old salaried professional with a net monthly income of Rs 95,000 applies for a home loan of Rs 25,00,000 at 9% per annum, repayable in 240 equated monthly instalments. Her only existing obligation is a car loan EMI of Rs 12,000; her credit bureau score is 780; she will retire at 60. The bank caps total EMI at 50% of net monthly income (FOIR) and does not lend beyond age 60 at maturity. The branch has prepared a sanction note assuming the full Rs 25,00,000 over 240 months at an EMI of about Rs 22,500. Separately, she expects a bonus of Rs 3,00,000 every March for the next five years and is deciding whether to prepay the home loan each year or park the bonus in a 7% fixed deposit; she is in the 30% tax bracket. The branch manager wants a written note answering both the sanction question and the borrower's query.
1. Verify the 240-month EMI and test the application against the bank's FOIR and age norms. What amount and tenure should the sanction note actually propose?
Read the worked answer
EMI check. EMI = P x r x (1+r)^n / [(1+r)^n - 1], with r = 9%/12 = 0.0075 and n = 240. (1.0075)^240 = 6.009, so EMI = 25,00,000 x 0.0075 x 6.009 / 5.009 = about Rs 22,494. The branch's figure is arithmetically right.
FOIR check at 240 months. 50% x Rs 95,000 = Rs 47,500; less the car loan EMI of Rs 12,000 leaves Rs 35,500. An EMI of Rs 22,494 fits comfortably. On FOIR alone, the full Rs 25 lakh is affordable.
Age check - the fatal flaw. She is 52 and the bank stops at age 60 at maturity. Maximum tenure = 96 months, not 240.
Recompute at 96 months. (1.0075)^96 = 2.049, so EMI = 25,00,000 x 0.0075 x 2.049 / 1.049 = about Rs 36,625.
That exceeds the Rs 35,500 ceiling by about Rs 1,125 a month, so the full amount is marginally unaffordable on the bank's own policy. The maximum loan at Rs 35,500 EMI over 96 months is 35,500 / 0.01465 = about Rs 24.23 lakh.
Recommendation: sanction about Rs 24.20 lakh for 96 months, or take a younger co-borrower (spouse) whose income and age support a longer tenure, which would allow the full Rs 25 lakh at a lower EMI. The sanction note as drafted is wrong on tenure and therefore wrong on EMI and eligibility.
2. Quantify the cost of the tenure choice and advise the borrower on prepaying each year versus investing the bonus in a fixed deposit.
Read the worked answer
Cost of tenure.
- 96 months: 36,625 x 96 = Rs 35,16,000, so interest = about Rs 10.16 lakh.
- 240 months: 22,494 x 240 = Rs 53,98,560, so interest = about Rs 28.99 lakh.
The longer tenure costs roughly Rs 18.8 lakh more interest in exchange for an EMI that is Rs 14,131 lower each month. Given that she cannot take 240 months anyway, the comparison is really between 96 months and a co-borrower-assisted longer tenure - she should choose the longer tenure only if the monthly cash-flow relief genuinely matters.
Prepay or invest. The loan costs 9% pre-tax. A 7% fixed deposit taxed at 30% yields 7% x 0.70 = 4.9% post-tax. Prepayment therefore earns about 410 bps more, risk-free, and every rupee prepaid on a reducing-balance loan removes interest for the full remaining tenure. Prepayment wins on arithmetic.
But adjust for two things.
- Section 24(b) allows deduction of home loan interest up to Rs 2 lakh a year under the old regime. Year-one interest at 9% on Rs 24.2 lakh is about Rs 2.15 lakh, so the deduction roughly covers it; at a 30% slab that is a tax saving of about Rs 60,000, cutting the effective cost to around 6.6% - still above 4.9%.
- Liquidity. She should hold an emergency fund of about six EMIs before prepaying, and note that on a floating-rate home loan to an individual, the RBI bars prepayment penalties.
Verdict: prepay annually after maintaining the emergency fund, and instruct the bank to reduce tenure rather than EMI so that the interest saving is not diluted.