If your loan amount is high, prepay to lower the monthly outgo; Invest the extra money at hand, if your loan is fixed at low rate.
We have a cultural milieu, which equates living without any debts, as a sign of righteous living. Understandably so. In the past, getting into a loan would have sucked one into a quagmire, as the interest rates charged were usurious. Plus, there was a stigma attached to being in debt. You can hold your head high, if you are debt free. That's the ethos and that’s why HDFC Standard Life's advertisement pitch ‘sar utha ke jiyo’, connected well with people. It was spot on, about being independent and fending off for oneself.
So it's easy to understand that when people take any kind of loan, they want to pay it off at the earliest. Those who take loans are on pins and needles. They do not want the Damoclean sword over their head. Even in a benign loan like a home loan, they would rather pay it off, the first thing.
Let's see if paying-off home loans is a good idea and if it is, under what circumstances.
Paying-off home loan has to be carefully weighed. It depends on the interest rate being charged, the loan amount, tenure, type of interest rate (fixed or floating), what percentage of salary is the equated monthly instalment (EMI) on the loan and so on.
One of the most important things to look for is the loan serviceability. Typically, if the home loan EMI is up to 40 per cent of the net income, it is deemed comfortable. The higher the EMI-income ratio, the worse it is. It would be a good idea to bring down the EMI as against your income. But, if there are other loans where you are paying a higher interest rate, it would be better to pay-off those loans earlier. Paying-off an auto loan or a personal loan may be a good idea as the interest does not give you any tax benefits like a home loan.
There is an equally valid argument for not prepaying a home loan – if you have investment options which will yield higher returns as compared to home loan. For instance, if the home loan interest rate is fixed at 9.75 per cent and there are options where the investor could potentially earn 12 per cent (like in equity mutual funds), he could invest the money and retain the loan. Even investment in public provident fund (PPF) at 8 per cent (post tax) could be good as the effective home loan interest rate could be less than 8 per cent considering interest repayment for up to Rs 1.5 lakh is deductible. In this case, the effective interest rate could be less than 8 per cent, making PPF a good option.
A lot depends on the quantum of loan, too. If the loan amount is huge, it may be a good idea to reduce the debt. For instance, if a person has borrowed Rs 1 crore loan, it may be a good idea to prepay and bring down the exposure. This argument will hold true even for a high income earner. Lets say a person has taken a loan of Rs 1 crore and his net monthly income is Rs 2 lakh, the ballpark EMI may come below Rs 1 lakh a month. This may look comfortable.
However, this person is exposed to a debt burden if there is a job loss or the pay cut like had happened with many in 2008 due to the economic slowdown. Even in such a situation, this EMI may be a huge burden. Assuming EMI is 40 per cent of the net income, here, 40 per cent (Rs 80,000) and a loan of over Rs 80 lakh. In this situation, it would be a good idea to prepay if one has the money.
A lot will depend on whether the home loan is on fixed rate or floating. Typically, if it is fixed at a fairly low level, say 10 per cent or less, one may allow the loan to continue and invest the surplus. For anything above 10 per cent, the effective rate has to be calculated taking into account the tax benefits. For a floating rate loan, a lot depends on the prognosis for the future and what is the current applicable rate. Suppose the interest rate has inched up to 12 per cent and is likely to go up further, it makes sense to start paying up.
For those with variable incomes, like self employed, the risk of a huge loan is pronounced. Such individuals should look at prepaying the loan, more so if their exposure is very high and the potential interest rate fluctuation is expected to be high, irrespective of other factors. Again, if the loan has been taken at very attractive level, say fixed at 7.75 per cent, borrowers could invest elsewhere, which helps them prepay whenever he/she want.
Sometimes, due to interest rate movements, the balance tenure may go beyond one's retirement age. In such situations, prepayment or increasing the EMI, in the earlier days, would be better and the loan tenure will fall within to the working life of the concerned individual.
If one has decided to prepay a loan, another option could be to increase the EMI, where possible. This ensures that the loan gets cleared in an accelerated manner and will work even in cases where lumpsum prepayments are not possible.
Over the years people have started losing their aversion towards loans, which is one of the reasons why real estate business is booming. But, if given a chance borrowers want to repay. Do not be paranoid about loans, just be careful.
The writer is a certified financial planner
