If you have cash lying around, should you use it to pre-pay your loan or invest it for higher returns? This is a puzzling question in personal finance. There are many answers to it. Each is tied to a different situation. The broad question is this: how do you decide what is the best use for your surplus money?
Firstly, let us understand the matter of solvency. If your assets are greater than your liabilities, you are solvent. For example, you might have a home loan of Rs 30 lakh, but your savings are Rs 50 lakh. In the event of an emergency, such as a job loss, you have the capacity to end your loan with a single payment. This position of financial strength should encourage you to focus more on investment than pre-payment. There is another way to look at solvency. Even if your liabilities exceed your assets, if you can keep servicing your liabilities every month, you are solvent.
If your liabilities are big, you should focus on loan payments. High-interest loans, such as credit card debt, and large loans, such as home loans, should be repaid on priority.
My chats with bankers, friends and family members with mortgages revealed to me that home loans often get paid off in less than half their tenures. The pay-or-invest deliberations are not a big part of the average homeowner’s decision process. They want to get out of debt fast.
Also Read: How to save money for short-term financial goals?
But consider the pros and cons. For example, for a Rs 50 lakh loan taken at 7 per cent for 20 years, if you pre-pay a single EMI (Rs 38,765) right at the start of the loan, your loan tenure reduces by three months and your interest by Rs 1.15 lakh. But if you invest the same money in an index fund returning 12 per cent for 20 years, you would save Rs 3.73 lakh. So why is the pre-payment better?
What ‘better’ is depends on what you want to achieve. You could focus on either debt payments or investments, or strike a balance between the two. We saw earlier in this chapter that the sweet spot for home loan pre-payment is 5 per cent of the loan balance once a year. You could go slower or faster on the basis of your situation or need. But looking at consumer behaviour, it can be argued that people want to be debt-free. It is a critical milestone for them on the path to Serenity. And so the appropriate amount of pre-payment should be done to achieve this objective.
Secondly, understand your priorities. Having adequate savings through an emergency fund, health and life insurance, and long-term investments are major priorities. If these needs have not been met, you should first focus on them. Once these needs are met, shift your focus to loan payments, while balancing it with your need to invest and be solvent.
Thirdly, do not be enamoured by tax deductions provided by your home loan. Pre-pay if your interest is high. This is especially important in the early stages of your loan. Your EMIs are money going out. They are the opposite of tax-saving investments such as PF, where the money remains with you. If you have spent Rs 2 lakh a year on loan interest, and if you are in the 30 per cent tax slab, you have not saved 30 per cent of Rs 2 lakh as a tax deduction. You have spent Rs 2 lakh. The tax deduction is merely a balm to salve the outflow.
Fourthly, if you have limited liquidity but still want to pre-pay, you could simply increase your EMI by the small margin of a few thousand rupees. This acts as micro pre-payment. It also keeps your savings free for investment. Investing strengthens your finances. The micro pre-payments accelerate your debt payment. This way, you can focus on both investing and pre-paying. This is better than opting only for one.
Lastly, consider how you have planned for your life and finances. If you have, for example, retirement coming up, then pre-pay. You can even pre-close the loan. You do not need to take the liability to retirement.
(The following is an excerpt from the new book on personal finance, The Bee, The Beetle and the Money Bug, co-authored by Adhil Shetty – CEO, Bankbazaar.com – and AR Hemant, and published by Rupa.)
