It is an interesting irony with Home Loans. Till the time a person does not have a home loan, he aspires to take one as soon as possible in order to purchase a home. Once he has taken a home loan, the first priority in his life becomes to repay his home loan even though it may come with a cost of his reduced standard of living. It is a prudent decision to repay a loan if one does not require it. After all why should you pay interest on a loan costing roughly 10% when you have idle funds sitting in your bank account account earning just 4% interest.
However there are a group of thinkers who do not believe in the philosophy of repaying back their home loans. Lets discuss the pros and cons of repaying a home loan and I will leave it to the readers to decide which is the best option suitable for them.
1. Reduction of Interest Payouts – The most obvious benefit out of prepayment is that your interest payout reduces. Prepayment of home loan results in an immediate reduction of the outstanding principal on the home loan which results in less interest being accrued on the loan account. For example, if you have an outstanding loan of Rs. 10 lacs at 10% interest, you would be annually paying approx Rs. 1 lac interest. If you prepay the loan by Rs. 1lac, your interest would reduce from Rs. 1 lac to Rs. 90K per year – approx 10 K saving per year for the duration of the loan.
2. Prepay – without reducing the tenure – Generally when you are going to prepay your home loan, you have two options. Either you can reduce the number of home loan installments or keep the number of installments same but reduce the monthly mortgage payments (EMIs). For example, if you prepay your home loan by Rs. 100,000, you may be provided two options :
a) Instead of paying your monthly EMI (e.g. Rs. 10K per month ) for original tenure of 120 months, reduce the tenure of the same monthly EMI of Rs. 10K to 110 months (illustrative) OR
b) Keep the original number of EMIs the same, e.g. 120 months, but reduce the monthly EMI per month from Rs. 10K to Rs. 9.5K, i.e. a reduction of Rs. 500 per month in monthly cash outflow.
I prefer the second option, as it results in improving the monthly cash flows by a lesser per month cash outflow and easing the family budgets. Any further cash savings on a monthly basis can then be used to further prepay the loan if needed.
3. Impact on Leverage
This is an interesting topic and in order to understand it let me take an example. John has an investment opportunity which requires Rs. 1 lac investment and it would provide him annually 15% return. His annual return in this case is Rs. 15,000.
Now lets bring in another situation, say John has just Rs. 20K in his pocket and he still has the same investment opportunity. John goes to a bank and takes a loan of Rs. 80K at 10% interest. His situation after end of the year would look like :
His investment – Rs. 20K and Loan to pay Rs. 80K.
Total Income from the investment (Rs. 1 lac @ 15%) – Rs. 15,000
Less Interest paid on Loan (Rs. 80K@10%) – (Rs 8,000)
Net Income for John Rs. 7,000
Return for John on his investment of Rs. 20K = 7K/20K x 100 = 35%.
The example above tried to show how leveraging work. Just like a normal LEVER is used to multiply the effort to lift heavy loads, financial levers use loans to multiple your returns – if used correctly. Generally if the interest rate paid out is less than the return earned from your investment, you would gain from taking a loan.
In case of a home loan, if you perceive that your property is going to give you a return of more than home loan interest rate, you would perhaps be better off not paying your home loan. This is just a general statement and each case would need a specific analysis.
4. Debt Equity Ratio – This is one of the classic financial ratios and perhaps one of the first ratios looked into by analysts to identify how risky a financial decision is and hence determining the respective financing cost (interest rate). It works opposite to the Leverage example above. While leveraging mentions that the more your loan is, the better would be your net returns. However, the contrary aspect associated with it is – the more loan you have (in % terms), the more risky your investment become to the lenders. For example
John has a property valued Rs. 10 lacs of which only 1 lac has been paid by John from his pocket and remaining 9 lac (90%)has been taken on loan. John hence has a debt equity of 9:1.
Peter has a property valued Rs. 10 lac of which his contribution is Rs. 3 lac and remaining 7 lacs (70%) has been financed via a loan. Peter has a debt equity of 7:3
If for examples real estate markets tank by 10% and the properties are now valued at 9 lac each, John’s stake would be reduced to zero and Peter’s stake would be reduced to Rs. 2 lac. If you are a financer giving a loan to John / Peter, you would rather want to avoid financing John as he is heavily leveraged and hence a more risky investor than Peter. In this example, John may walk away as he would not have any incentive to hold his property (considering it is less than the value he purchased and his entire investment has been wiped out). On the contrary, Peter would still be inclined to hold on to the property considering he has still 2 lacs of this investment in the property. Hence, even if the bank would want to finance John, they would charge a higher interest rate for the extra risk in that decision.
The reason why I explained the above – you may want to prepay your home loan to bring it within a comfortable debt equity ratio. Ideally this ratio is 7:3 to 8:2 i.e. Loan to Value of your property is 70%-80%. You may want to go even higher at 60%, but from there you start to adversely affect your leverage ratio. Banks in many cases provide a better interest rate deal (specially outside India) if the Loan to Value is greater 80% or lower.
5. Use Mortgage as an Overdraft Account
This is one of the least used options available in the market. Outside India, the product is generally called as an Offset mortgage. In India, the product is sold by State Bank of India by the name Max Gain. In this type of mortgage account, if you have surplus funds, you can deposit the funds in your bank / mortgage account and interest shall be computed on the balance mortgage loan. You are free to withdraw the deposit and the interest shall levied on the remaining balance. Hence, when ever you have surplus funds, you reduce your interest payouts. If you find an investment opportunity, you can withdraw the funds from your mortgage to fund your investments. By this way, you tend to get a good mix of putting surplus funds into work (by reducing interest payouts) and at the same time having the flexibility to get the funds back when needed. It is important to note that any deposits made in such an account do not end up reducing your mortgage balance permanently. The excess funds temporarily suspend interest accruals on the deposited amount till such a time these funds are not withdrawn by the account holder.
6. Create Investment Vehicle to Prepay – Should you still want to prepay, instead of paying your loan off, put the prepayment amount in an investment vehicle such as a Mutual Fund SIP. Our blog post Should I Prepay my Loan Or Invest Till End of Tenure explains this in detail.
In line with above mentioned paragraphs, you may want to revisit your current home loans / mortgages and analyse which side of the fence you are sitting. You may have a very high leverage and sitting on excess cash – probably a good idea to repay a bit of your loan. Alternatively, you have paid a good part of your loan and hence you may want to invest your excess cash in other investment options to avoid reducing the impact of leverage on your home investment decision. You may also want to refer to my alternative article Good Loans & Bad Loans and specifically for NRIs – NRIs – How to Leverage on Low Interest Rates.