ARTI ARORA CFP CM | HEAD FINANCIAL PLANNER
In the course of our financial lives, one is faced with many choices and every choice comes with a trade-off. Assessing the trade-off and understanding nets is crucial to taking the right financial decisions in life.
House purchase is one of the most common financial goals for most individuals and families. Typically, the achievement of this goal comes with a home loan that one takes to be able to fund the goal. Home loans are the most productive and tax efficient form of debt that one can take. But the effect of the loan on one's budget, overall cash flows and savings plan must be considered wholly before deciding to go for it.
Having taken the home loan, there remains a constant urge to pre pay it especially when surplus funds are available in form bonus or any other windfall. At this point in time, there are two alternatives before oneself; either pre pay the loan or invest the surplus funds. This decision involves dichotomy of sorts and must be objectively assessed before taking the final call.
A couple of important points to consider when evaluating this decision –
- The cost of your home loan is not the rate of interest you are paying on it. The EMI calculation involves monthly compounding and so while your home loan rate may be 7.5%, effectively you are paying more. The difference may be a few hundreds per month but on an annual basis, it may be a few thousands too and over a certain term of say 3, 5 or 10 years, this difference will only keep going up. So, it is important for you to understand the real cost of your home loan.
- If you happen to check your loan amortization schedule, in the first few years, you are only paying back interest and the principal repayment to a larger extent starts later. If you have already been in the loan for half of the loan duration, it really doesn't matter whether you pay back the loan or keep paying the EMIs. That is to say that an earlier repayment is a more rewarding option at all times.
- You pay interest on your home loan and earn returns on investments. The difference between the two needs to be analysed before deciding to pre pay the loan. The wider this margin is, the better it is to continue with investments, earn better returns and after having accumulated a sizeable corpus in a few year's time, use it to pre pay the loan. The additional returns will be your bonus and the liability too will be off your head.
- The home loan comes with tax benefits too which must be factored in to assess one's tax liability with and without the loan to be able to do the maths better. Penny saved is a penny earned and likewise for tax saved.
- Last but not least, liquidity is another important factor to be considered before taking this call. If you have enough of it to be able to meet any emergency requirement and also to benefit from any opportunity that may come your way in the interim, you can consider prepaying the loan. If not, it doesn’t make sense to compromise your present for the future. Living in a deprived state just because you don’t want a liability is not rational at all.
To conclude, there is always a middle approach that one may take. Rather than prepaying the loan in entirety, one can opt for part pre-payment of the loan. This way, the loan pressure gets eased and there is enough liquidity to benefit from growth investment opportunities as well as any unforeseen expenses that may arise. The last 15 months have given enough reasons for one to plan the course of their financial life and do not take the liquidity need lightly.