Publication:The Times of India Mumbai; Date:Aug 19, 2008; Section: Your Money; Page: 21
Street Smart
Consumers should not just look at the absolute numbers and decide whether to retain the loan, prepay partly or complete the payout
There is a lot of hue and cry these days about prepaying home loans. Often, every newspaper will carry some sort of analysis on how the floating rate home loan holders have suffered and if it’s time to prepay. Some analysis clearly suggested that one must prepay the loan considering the interest rates and tenures, which have gone up significantly.
However, the analysis cannot be as basic as it sounds because every individual’s situation is unique. There are several factors that one must consider—right from an individual’s current financial situation, liquidity needs in the future, are the interest rates likely to remain at the same level throughout the tenure and finally whether alternate investments can provide any better returns.
For a moment, let us consider that interest rates are likely to remain at 12% for the next 20 years. Also, consider that you might just earn 8% compounded returns on your investments. For most people the analysis is done. It’s better to prepay the entire loan or not opt for one at all. After all, isn’t 12% interest outgo better than 8% returns? Anyone with a little bit of common sense will affirm.
So, should you prepay the entire loan or not borrow at all?
Read carefully before you jump to any conclusion as the reality is completely different from what meets the eye.
once, I slightly differ because 8% compounded returns are much better than the 12% home loan interest rate. Remember Albert Einstein and what he said about compounding being the eighth wonder of the world. Does anyone recollect this?
The interest rate for a home loan is always calculated on the reducing balance methodology. This means that your interest is calculated every month (or a frequency as per the terms of the loan) on the outstanding loan amount. This also means that your equated monthly instalment (EMI) has been calculated not on the basis of 12% flat rate on the entire loan amount, but 12% on the outstanding loan amount every month.
Let’s take an example of Ravinder Singh availing a loan of Rs 25 lakh for 20 years. Assume that the interest rate of 12% today remains constant throughout the term. Does this mean that Ravinder is paying Rs 3 lakh (12% of Rs 25 lakh) as interest every year? If this was true, he would then end up paying Rs 3 lakh multiplied by 20 years, which works out to Rs 60 lakh as interest. By any means he is not paying this kind of interest as the interest rate here is not calculated on a flat rate basis, but on a reducing principal basis.
Thus, the total interest paid over a 20-year period for this loan would be Rs 41,06,517. This means that the total interest plus principal of Rs 25 lakh paid would be Rs 66,06,517.
Ravinder also puts Rs 25 lakh in an investment simultaneously that would give him 8% compounded returns every year for the next 20 years. What do you think the corpus would be at the end? A staggering Rs 1.16 crore. This is Rs 50 lakh more than the amount that he would have paid the bank. If he manages to earn 10% and 12% respectively, his corpus at the end of 20 years will be Rs 1.68 crore and Rs 2.4 crore.
This means on a return of 12% compounded (same rate as your home loan), he will be left with a difference of Rs 2.4 crore minus Rs 66 lakh, which amounts to Rs 1.74 crore.
The above calculations are excluding the tax benefits Ravinder might get which would further subsidise the loan and increase the overall benefits.
So, are you still saying that one should queue at the bank to pay off the loan. This might not look like a great idea. Here are some pointers:
Don’t look at the absolute numbers and decide whether to retain the loan, prepay partly or complete the payout .
Review your amortisation schedule and calculate the exact interest plus principal that you are bound to pay over the duration of the loan. In short, calculate the total payout to the bank or financial institution.
If your tenure has gone up substantially, look at making minor one-time repayments to bring the tenure down to the original one. Prepay the amount that you can do so without any penalty. Start making incremental EMI payments if you cannot make one-time payoffs. Even if you are unable to do so, do not fret. All is not lost. Floating rate loans will not remain high forever and they are bound to come down. Don’t overstretch yourself when you buy a house and always keep a buffer for higher EMIs.
If you have the means to pay off the entire loan, still don’t just queue at the bank. Look at the potential investment options and evaluate whether you can earn 8%, 10% or 12% returns on such investments in the next 20 years. Investments such as Public Provident Fund (PPF) will deliver 8% compounded returns (but the 8% is not guaranteed as interest rates are not locked in and can come down. If PPF rates come down, so will interest rates across the board.) Equity on the other hand has the potential to give 10% returns in the next 20 years. Which means you can be richer by a cool Rs 1 crore (Rs 1.68 crore minus Rs 66 lakh).
If you are planning to take another loan after some time, don’t pay off the home loan as it’s still the cheapest form of loan next to taking an overdraft on fixed deposits.
Finally, Ravinder decided to utilise his funds for business as he is very confident of earning 10% compounded returns in his business and other investments. At the same time, he has decided to avail the home loan at 12%. We couldn’t agree more.
Amar Pandit is a Certified Financial Planner and Director, My Financial Advisor
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