One of the top priority of any bread earner is to buy a home and this often comes up with a costly price in the form of a housing loan. Once the loan has been take, the next priority becomes paying the loan off, specially when it comes to Indian culture where running a home loan till its scheduled life is unheard off. People would want to pay it off so that it is one lesser thing to be worried off.
We have written an article on Pros and Cons of Home Loan Prepayment and it is heavily commented by the readers. The idea of this post is to further the discussion raised in our earlier post and talk about an interesting option which may convince a few readers to avoid prepaying their loan installments and rather invest their prepayment budgets in an investment vehicle which over the tenure of the loan may result in a multi time more money saving than the interest saved via prepayment.
The idea can be best explained with an example. For the purpose of this article lets assume Chris buys a flat worth Rs. 1 crore in Gurgaon and pays Rs. 25 lacs as initial downpayment. Remaining Rs. 75 lacs is financed by way of home loan which carries an interest rate of 10% over a tenure of 25 years. Monthly mortgage (home loan emi) comes to Rs. 68,153.
CASE A : If Chris continues to repay Rs. 68K per month towards the home loan for the entire tenure of the loan for 25 years, he would have paid 300 monthly installments. Over 25 years he would have paid Rs. 1.29 crores as interest to the bank and his total outflow would be Rs. 2.04 crores for a loan amount of Rs. 75 lacs.
CASE B : Chris decides that he would want to get rid of the loan at the earliest as he doesn’t like the idea of paying Rs. 1.29 crores as interest to the bank towards a loan of Rs. 75 lacs. He pre-pays Rs. 15K per month in addition to his monthly mortgage installments of Rs. 68K. His total monthly outflow is Rs. 83K and he finishes his loan off in 168 installments. He pays 64 lacs towards interest and his total outflow including interest towards loan repayment is Rs. 1.39 crores. He saved paying interest of Rs. 64 lacs by choosing prepayment option. Smart ? Would you choose this option as well ?
John also took a similar property of same value on same interest terms. His home loan terms were exactly same as Chris i.e. 10% p.a. for 10 years. However, instead of prepaying the amount to the bank, he chose to invest Rs. 15K per month in mutual funds for 14 years (168 months). For next 14 years, his monthly cash flows were as follows :
1. Paying loan installments : Rs. 68,153
2. Investing in Mutual Funds : Rs. 15,000.
After 14 years (168 months) John’s financial situation is summarized in the table below.
John’s investment in Mutual funds would have grown to Rs. 84.72 lacs if his investments grew at 15% per year. Since he did not pre-pay his loan like Chris, his outstanding loan balance after 168 months (14 years) is Rs. 54 lacs (row 2 in the table below). He can now sell his investments of Rs. 84.72 lacs and pay off his entire loan of Rs. 54 lacs and still be left with Rs. 30 lacs.. Nice ? If he was more luckier with his investments growing at 18% per year, he may be left with Rs. 57 lacs instead of Rs. 30 lacs after paying off his loan.
Now let me leave this question with you to ponder.
Who is smarter in managing his finances ? Is it Chris who regularly prepaid his loan and completely settled his loan by 168th month ? Or is it John who chose not to prepay the loan but rather invest the amount of his prepayment budget in a mutual fund which grew faster than the interest saving he could have made should he have acted like Chris. After all he was left with a handsome Rs. 30 lacs even after paying his loan off at the same time as Chris !