To optimize the debt payoff journey, it is essential we realize the following aspects:
Interest accrues on the balance outstanding at any point in time. As the balance outstanding at loan start is higher than towards the end of the loan, most of your Equated Monthly Instalment (EMI) at the start of the loan accounts for interest and only a small portion goes into repaying the principal. Over time, as the principal balance reduces, interest accrued on outstanding amount reduces and therefore, a greater amount of the EMI pays off the loan principal. Thus we can note that the loan balance depletes slowly at the start of the loan and gathers pace as time goes on. That makes it in the Bank’s interest to keep the borrower in the first half of the repayment schedule, where the interest payment proportion is high, rather than the second half when less interest is accruing.
To minimize interest paid during the life of the loan, you should repay lumpsum amounts towards principal as and when you come across additional money. In case of salaried employees, one of the best uses of the annual bonus payout is to throw it at the loan, as this repayment is a guaranteed return of your current EMI rate. The balance outstanding is reduced, bumping up the interest portion of the EMI, while also reducing the interest accruing daily as the balance is smaller.
Stepping up your EMIs
In addition to periodic lumpsum payments, the borrower should also aim to repay the loan faster by stepping up the EMI amounts. Any increment in your salary should also increase your EMI amount by at least the same proportion. This also has the benefit of reducing the cashflow into your account, thereby preventing lifestyle creep.
If the amount paid by a borrower on a monthly basis is LESS than the amount of interest accrued on the outstanding amount for that month, the loan is in “Negative amortization”. 100% of the amount paid goes to the interest and the amount of interest in excess of the amount paid is added to the principal outstanding. The loan balance increases and your loan is never repaid. It’s therefore essential to ensure that at a minimum the EMI amount exceeds the interest accrued from day 1 of the loan to prevent the borrower from being ensnared in a debt trap.
Impact of changes in Interest Rates on Loans
The interest rate may be either fixed or floating. Fixed interest rates do not vary over the duration of the loan, while floating rates are reset on a periodic basis (say quarterly) in line with an agreed upon benchmark. In India, Banks currently use the Marginal Cost of Lending Rate (MCLR) to determine the interest rate of the loan. The amortization schedule automatically adjusts the interest and principal component of each repayment to a changed interest rate, so any variation in the interest rate reflects in a change in the end date of the loan – A reduction in the rate reduces the number of pending instalments, while an increase in the rate adds more instalments to the end of the schedule. While the borrower does not feel the impact as the same amount is debited from his account every month, he will be in debt for longer or shorter on the basis of the upward or downward adjustments in the interest rate.