For any Home Loan Borrower, to prepay Home Loan is topmost priority. As i discussed in my earlier posts that Home Loan interest increase the overall cost of property. Some of my readers mentioned that they are availing tax deduction but they ignored the fact that they lost HRA (House Rent Allowance) component. At macro level, if your property is appreciating at 10% and at the same time you are paying 10% interest on Home Loan then net/real appreciation is NIL. Currently world economic crisis is keeping property prices under check. Instead of appreciation, property rates are decreasing in most of the pockets in all big cities. Therefore double digit property appreciation is a mirage. Though it is not a universal thumb rule that to prepay Home Loan is best option in current scenario. At the same time it is best option for atleast 90% of the cases. As i always mention that any kind of debt is not good for financial health. Average Home Loan tenure in India is 7-8 years therefore being a smart borrower we should utilize each and every opportunity to prepay Home Loan. Lets check out how we can prepay Home Loan faster
Increase EMI with Increase in Salary
At the time of approval of Home Loan, Home Loan provider fix EMI at 40%-50% of take home salary. Unfortunately with increase in salary this ratio keep dropping. To Prepay Home Loan faster, it is necessary to maintain this discipline. For example, at the time of availing Home Loan your take home salary is 50,000 and Home Loan EMI is 20000. After few years, take home salary increased to 80,000 therefore EMI to Salary ratio reduced to 25% from 40%. To prepay Home Loan faster, it is always advisable to fine tune EMI ratio with increase in salary. In this case, ideal EMI should be 32,000. By maintaining this discipline, We can prepay Home Loan within 7-8 years.
Annual Bonus
Last week, i met one of my family friend. This friend of mine bought a flat in Mumbai for 1 Cr. Every year he gets annual bonus of 8-10 lakh and family spend this amount on vacation abroad. Currently he is serving a Home Loan of 70 lakhs. From personal finance perspective, it is wise for him to prepay Home Loan to reduce interest burden. In basic principles of marketing you come across 3 terms i.e. Need, Want and Demand. In layman terms, Need is basic human requirement & Want is human need shaped by social, cultural and individual personality. Owning a house for shelter is need whereas want is like owning consumer durable, eating out etc. Demand is when an individual wants something which is premium with an ability to pay. In my friends case, flat is need but foreign vacation is demand. Need, Want and Demand should be fulfilled in same order. Therefore in my opinion, wise decision is utilize annual bonus to prepay Home Loan which will help him to save substantial amount as interest on Home Loan.
Investment
Another big dilemma of a Home Loan borrower is whether to invest or prepay Home Loan. To simplify this complex problem we can take help of concept of notional/opportunity loss. Let’s take an example of two of my clients Person A & Person B.
(a) Person A is paying Home Loan EMI of Rs 20,000. His home loan rate of interest is 10.75% and take home salary is Rs 45,000. By maintaining strict financial disciple he is able to save Rs 4,000 per month. Now he asked me that he would like to invest Rs 4,000 per month in PPF. Going by financial prudence, Person A will get return of 8.7% if he invest in PPF but at the same he is not considering that fact that if he divert this amount i.e. Rs 4,000 towards Home Loan EMI then he can save interest of 10.75% on this amount. For every 100 Rs invested in PPF, he is earning an interest of Rs 8.7 per annum but there is notional loss by way of Home Loan interest i.e. Rs 10.75. In short, for every 100 Rs there is an opportunity loss by way of potential saving of Rs 2.05 towards Home Loan interest outflow. In layman terms, it makes sense to invest if you are sure of generating returns more than Home Loan interest rate otherwise its a wise decision to prepay Home Loan. If you divert savings to prepay Home Loan then you will be earning indirect returns equivalent to Home Loan interest rate.
(b) Person B is paying Home Loan EMI of Rs 40,000. Before availing Home Loan, he invested in Mutual Funds and Bank FD’s. Annualized return from Mutual Funds is 10% and from bank FD’s is 9.75%. Now he asked me whether to liquidate investments and prepay Home Loan or continue with investment. Applying same logic of Person A, Returns from existing investments is less than Home Loan Interest rate therefore it makes sense to liquidate the existing investments and prepay Home Loan. By doing this, he will be generating indirect returns equivalent to Home Loan interest rate through Home Loan interest savings.
Word of Caution:
(a) It is advisable to maintain 3-6 months monthly expenditure as contingency fund
(b) 3 months EMI as reserve for any adverse situation like job loss, medical emergency etc.
(c) If you are withdrawing money from investments meant for specific purpose e.g. PPF is for retirement then you should have future plan in place to top up PPF account with equivalent amount through savings within specified period.
Contingency funds should never be touched. Liquid debt mutual fund is one of the best option to park contingency fund.
Home Loan for Income Tax Savings
This is one of the common excuse not to prepay Home Loan. This is one of the marketing gimmicks to highlight positive side & ignore other side of the story. Home Loan should only be taken to reduce lead time between owning a house with own funds and borrow today to own a house to hedge against increasing/cost of owning a property.
If Home Loan is availed just to take benefit of Income tax deductions, in my opinion it is not a wise decision. I can discuss this topic in detail but do remember that for self-occupied property there is loss of HRA tax benefit and for let out property, benefits from rate of appreciation & loss from let out property should be high enough to compensate for interest outflow.
When to Prepay Home Loan
As we know that during initial years of Home Loan, interest outflow outweigh principal payment. Whereas towards the end of Home Loan tenure, principal payment is more compared to interest payment. Therefore as a thumb rule, financially it is more beneficial to prepay Home Loan during first 7 years of Home Loan. Before taking any decision in this regard, it is advisable to do cost-benefit analysis. Though it is not a universal rule, decision may vary from case to case basis.
As we observed through this post that through proper financial planning and informed decision making we can maximize returns from our hard earned money. Returns does not mean only to Earn from investment but any Potential Saving by way of reduced interest outflow is indirect return on investment. This concept of Reverse Return on Investment is currently not popular in India. Hope you liked the post and suggestions on how to prepay Home Loan faster. You can share your comments, feedback and suggestions through following comments section
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