Early payback decision needs deliberation. Get an income tax payment schedule, and invest in debt-based instruments for liquidity in the near future.
The rise in interest rates have resulted in home loan borrowers shelling out higher equated monthly installments (EMIs) or increasing the tenure of their loan while retaining the same EMIs. Many have resorted to prepaying their loans to reduce the burden. But paying off loans without a structured plan can lead to serious cash flow problems.
Let’s understand this through Prakash Kadam’s experience. In 2004, Kadam had bought a home with a loan worth Rs 25 lakh. By mid-2008, the total due was close to Rs 23 lakh, and the EMI was Rs 20,000. Determined to repay the loan before its tenure,Kadam started prepaying his home loan every quarter of 2009.
He prepaid Rs 5.95 lakh by March 2009, another Rs 4 lakh by June 2009, Rs 2 lakh by September 2009 and then, for six months, he chose to raise his EMI to almost Rs 32,000 a month. April 2010 saw another Rs 5.5 lakh being prepaid and by end of May 2010, he foreclosed the entire loan by paying off the balance Rs 2.3 lakh, inclusive of interest and other charges.
But even as Kadam prepaid his loan, he purchased a luxury car without resorting to a car loan in December 2010. It cost Rs 10 lakh.
As a consultant, Kadam was responsible for managing his taxation and other statutory liabilities on his own. These came for close scrutiny in the last quarter of 2011. On a closer look, Kadam, with the help of his consultant, discovered he owed close to Rs 2.5 lakh for the statutory payments on his service income, all of which had to be paid by March end. Plus, another Rs 1.5 lakh was due as advance taxes, payable on his total income earned during the year. Both liabilities surprised Kadam as he had not anticipated these. Nor could these be delayed. He encashed his fixed deposits to clear these.
Continuing to set aside from his monthly income, he had also initiated some systematic investment plans (SIPs) into equity funds, of Rs 25,000 a month.
In May 2011, business was not as good as earlier and this had a direct impact on his monthly income. With the overall economy slowing and companies cutting expenditure, Kadam found it difficult to engage new clients for his niche service. These meant additional pressure on Kadam’s emergency/contingency fund, which already had been dented by Rs 4 lakh in March.
The balance part of the taxes payable on his income came up for payment in July 2011, the due date for filing his return on income. Prakash was forced to dip into his emergency fund. Although he had initiated SIPs over recent months, all were into equity and sectoral funds. With equity markets displaying lacklustre performance since the beginning of 2011, he was in no mood to redeem these at losses to meet his other obligations.
Kadam’s case is a good example on borrowers needing to plan for the prepayment of loans. Had Kadam been a little slow in paying off his loans, his financial situation would have been easier. So, here’s what he should have done - Repaid every six months instead of every quarter.
Any part or full prepayment of a loan requires cash flows to be examined for over at least a five year period. The long period, gives leeway for any unforeseen ups and downs in the income pattern to be met. Any windfall income or receipt, not accounted for earlier, could be used for prepayment.
A prepayment should be done by either increasing EMIs or paying off a lump sum amount it intervals. Combining both these strategies, like Kadam did, is not advisable.
Savings done during a planned prepayment period, should be in debt-based instruments to provide for liquidity in the near future. Kadam chose equities over debt.
It is essential to have one’s income and tax forecast for the period over which the prepayment is being planned.
Financial planning is misunderstood as only an exercise to plan and execute investments for the future. Yet, cash flow forecasting and management is also an integral part of such a plan. While forecasts for businesses can go haywire, a loan prepayment can still be planned.
All the projections for this purpose should be done in the most conservative manner. It’s only when such projections show a proper match between cash inflows and outflows and also shows room for prepayment that one should plan this. Also, at the time of prepaying, it is essential to so structure your monthly investment pattern that at least half should be accessible at any point in time.
The writer is a certified financial planner
