Don’t Rush To Prepay Your Loans
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07 Aug, 2018
With the recent hike in rates by the RBI and increase in bank rates, most of us are in rush to repay our home loans and quickly get the burden of the ‘dreaded loan’ off our heads. In fact, every newspaper is carrying some sort of analysis on how the floating rate home loan holders have suffered and whether they should prepay their loan.
Before you take any such hasty decision of repaying your home loans, take a look at a few mistakes you should avoid when it comes to loan repayment –
Mistake 1: Looking at your loan in isolation without understanding its impact on overall financial requirements
Mr. Pai, one of our clients, had taken a home loan of Rs. 1 crore for a period of 20 years at a 9% p. a. interest rate. At the end of 20 years, at an EMI of Rs. 89,973 per month, he would have paid a total of Rs. 2.16 crore, as shown below.
|Year||Loan Repayment Amount|
|1 to 20||Rs. 10.79 lakh every year|
|Total||Rs. 2.16 crore|
He was in a comfortable position to pay his EMIs however as soon as he received a windfall inheritance he was in a tearing hurry to prepay his loan. While there is no financial reason to prepay his loan, he has an emotional urge to pay off the loan. The increasing rates are increasing his anxiety as well and he wished to utilise the entire Rs. 1 crore he received as inheritance to repay his loan immediately. When we explained to him that he should invest the Rs. 1 crore inheritance in mutual funds and continue his EMIs, he was in disbelief. Have a look at why investing your money is better than prepaying your entire loan.
Rs. 1 crore invested in Bank FDs and Mutual Funds
|Year||Investment in Bank FD at 3.92% p.a. post-tax||Investment in Equity at 12% p.a. post-tax|
|1||Rs. 1.04 crore||Rs. 1.12 crore|
|2||Rs. 1.08 crore||Rs. 1.25 crore|
|3||Rs. 1.12 crore||Rs. 1.40 crore|
|4||Rs. 1.16 crore||Rs. 1.57 crore|
|Year 5 to 17|
|18||Rs. 1.99 crore||Rs. 7.70 crore|
|19||Rs. 2.07 crore||Rs. 8.61 crore|
|20||Rs. 2.16 crore||Rs. 9.64 crore|
Thus, as you can see above, if Mr Pai invests his inheritance in a Bank FD instead of prepaying his loan, he will earn Rs. 2.16 crore at the end of 20 years – the exact amount to recover his EMI payments of his home loan. However, if he invests the Rs. 1 crore in mutual funds he will accumulate substantial money at the end of 20 years. His investment will amount to Rs. 9.64 crore which will not only cover his EMI payments for the loan but also grow his wealth.
So why not grow your wealth while comfortably paying your EMIs? Also, for everyone who has taken a home loan it is important to keep in mind that if you have secured the loan at a low rate of interest it does not make any sense to pay it off especially if you have any liquidity needs in the near future.
Mistake 2 – Not taking into consideration the deduction available on interest payment of home loans while determining how much loan to take
You are eligible for a deduction of Rs. 2 lakh every year under section 24(b) of the Income Tax Act, 1961, from your taxable income for the interest you pay on your home loan. Thus, it is important to keep the loan amount in such a way that you have an interest cost of Rs. 2 lakh a year to take maximum advantage of the deduction available. Remember, the higher the interest rate, the less loan you should take.
Thus, when it comes to loan repayment, do not look at the absolute numbers and rush to repay your loans without first understanding your liquidity, other monetary requirements and goals during the loan repayment period. You should also regularly review your amortisation schedule and calculate the exact interest plus principal that you have to pay over the duration of the loan.