22 August, 2010

How do I decide if prepaying the home loan is better or investing my surplus is better?

Taking a loan is taboo in India. 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... reason why HDFC Standard Life’s “Sar Utha ke jiyo”, connected so well with people. It was spot on, about being independent and fending off for oneself.
So it’s easy to understand why, when people do take loans ( even home loans ), they want to pay it off at the earliest. Those who take loans are on pins and needles. They do not want the Damocles sword over their head. Even in a benign loan like a home loan, they would rather pay-off, first thing.
Let’s find out if paying off home loans is good and if it is, in what circumstances.
Paying off home loans has to be carefully weighed. It depends on the interest rate being charged, the quantum of loan taken, tenure of the loan, if it is fixed or floating, what percentage of salary is the EMI on the loan etc.
1. One of the most important things to look for is the serviceability issue. Typically, if the home loan EMI is upto 40% of the net income, it is deemed comfortable. The higher the percentage, the worse off it is. It would be a good idea to bring down the home loan to a 40% level. But, if there are other loans where you are paying a higher interest rate, it would be a better idea to pay off those. Paying off an auto loan or a personal loan may be a good idea as the interest does not give you any tax breaks either.
2. 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 the home loan. For instance, if the home loan interest rate is 9.75% fixed and there are options where the investor could potentially earn 12%, like Equity Mutual Funds, (s)he could invest the money and retain the loan. Even investment in PPF ( @ 8% post-tax interest ) could be a good idea as the effective home loan interest rate could be less than 8% considering the fact that interest upto Rs.1.5 Lakhs ( under Sec 24(B) ) is deductible against the gross taxable income. In this case, the effective interest rate could be less than 8%, making PPF a good option.
3. A lot depends on the quantum of loan too. If the loan is huge, it may be a good idea to reduce the loan. For instance if a person has taken, say, a Rs.1 Crore loan, it may be a good idea to prepay and bring down the exposure. This argument will hold good even for a high income earner. Let us say, a person has taken a loan of Rs.1 Crore and (s)he is earning Rs.2 Lakhs net income per month, the ballpark home loan may come to under Rs.1 Lakh a month. This may look comfortable.
However, this person is exposed if there is a loss of job or the income reduces in future, for some reason. Even in a situation where (s)he has to go on leave without pay, this EMI may be a millstone around the neck. In such situations, one could consider prepaying even if the home loan EMI is only 40% of the net monthly income. In this instance, 40% would mean an EMI of Rs.80,000/- and a loan of over Rs.80 Lakhs. In this situation, it would be a good idea to prepay if one has the money for reasons explained above.
4. A lot will depend on whether the home loan is a fixed or a floating rate loan. Typically, if it is fixed at a fairly low level, say 10% or less, it may be a good idea to allow the loan to continue and invest any surpluses one may have. Beyond 10%, the effective rate has to be calculated taking into account the tax benefits and then decide whether it makes sense or not. For a floating rate loan, a lot depends on the prognosis for the future and where the loan rate has reached. Suppose the rate is at 12%, it may make sense to start paying up. If interest rates are expected to go up, it will be a trigger to see if prepayment makes sense.
5. For those with variable incomes, like those in business, the risk of a huge loan is pronounced. They should consider prepaying loans, especially if their exposure is very high and the potential fluctuations are expected to be major, irrespective of other factors. Again if the loan has been taken at very attractive levels like say 7.75% fixed for the tenure, they could consider investing elsewhere, which keeps the option to prepay whenever they want.
6. Sometimes, due to interest rate fluctuations, the balance tenure may go beyond ones retirement age. In such situations, prepayment or increasing one’s EMI would be a good idea to bring down the tenure down to the balance working life.

If one has decided to prepay a loan, a good way would be to hike 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 real estate is booming. But, given a chance people want to repay. They can, after taking into account the various factors discussed here. One need not be paranoid about loans… one just has to be careful.

Published in Business Standard on 22/8/2010

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