Why interest depends on the balance, not the EMI
Indian retail loans are almost always reducing-balance loans. Each month the lender charges interest on whatever principal is still outstanding, and the rest of your instalment reduces that principal. Early in the loan the balance is high, so most of the EMI is interest; late in the loan the balance is small, so most of it is principal.
This is why the timing of extra payments matters so much. A rupee of principal repaid in year two removes interest for every remaining month of the loan. The same rupee repaid in the final year removes almost nothing, because there was hardly any interest left to charge.
Three ways to reduce total interest
All three work through the same mechanism — a lower outstanding balance, sooner — but they feel very different in your monthly budget.
- Shorter tenure at sanction: the EMI is higher, but the balance falls faster from month one. This usually saves the most interest.
- Lump-sum prepayment: a bonus, maturity proceeds or a windfall applied to principal. Ask the lender to reduce tenure rather than EMI if you want the interest saving to be largest.
- Small monthly top-up: paying a few thousand rupees above the EMI each month has a surprisingly large cumulative effect over a 20-year loan.
When prepayment is not the best use of cash
Prepayment is a guaranteed saving equal to your loan's interest rate. It still competes with other uses of the same money. Keep an emergency fund intact first — an illiquid house does not pay next month's bills. If you hold high-cost debt such as a credit card revolve or a personal loan at a much higher rate, clear that before touching a cheaper home loan.
Also check the fine print. Floating-rate home loans to individuals generally have no prepayment charge, but fixed-rate loans and many personal or car loans can carry one. A penalty of two per cent on the prepaid amount changes the arithmetic.
How to test it with real numbers
Rather than reasoning in the abstract, run your own figures twice. First calculate the EMI and total interest for the tenure you have been offered. Then reduce the tenure — or reduce the principal by the lump sum you could pay — and compare total interest between the two. The difference is the actual saving, in rupees, for your loan.