He owns multiple credit cards and does not balk at rolling over credit from time to time. The 38-year-old businessman is currently servicing a car loan and a home loan as well. His business has done particularly well in the previous financial year and he wants to use the windfall to pay the principal amount of their home loan. However, his wife would rather use the extra money to repay the credit card debt. Whose idea is better?
While most people are wont to side with Mazumdar instead of his wife when it comes to paying the
debt, financial experts are of a different opinion. This is because while considering the prepayment of a loan, there are several factors that one should keep in mind.
Power of prioritising
It is advisable to pay off the costliest loan first—not the fattest one in terms of the EMI outflow—in order to reduce the interest cost burden. “You can start by paying any credit card loan as these carry the highest interest burden, to the tune of 35-40% annually, compared with 12-13% for a housing loan,” says Maalde.
After taking care of the costliest loan, you should tackle the unproductive ones. A home loan, for instance, fetches tax benefits for the investor, while a personal or car loan does not. If you have taken a home loan, you can claim a deduction of up to 1.5 lakh a year for the interest paid under Section 24, while the principal amount repaid up to 1 lakh qualifies for deduction under Section 80C. In fact, you can claim the full interest outgo for a house that is not self-occupied, and the same applies for a study loan under Section 80E of the Income Tax Act. In case of prepayment, this benefit gets reduced. Similarly, a businessman can claim deduction on expenses such as a car, which makes a car loan productive too.
The tenure of a loan is another crucial aspect that needs to be considered. “Suppose that you have taken two loans with similar interest rates. In this case, the tenure should be the deciding factor when it comes to prioritising the loan that needs to be paid first. This is because every additional instalment increases the overall interest cost burden of the borrower,” he explains.
Opportunity cost
The above analysis does not apply strictly if the only debt you have taken is a home loan. In such a situation, on landing a windfall, instead of rushing to prepay the loan, first weigh all the options open to you. Chances are that the same money would earn you a decent sum if you invest it. So, if you find an investment option that is yielding a return of, say, 15-18% annually, it’s obviously a better use of your money than prepaying a home loan for which the interest rate is around 14% a year.
Pai recommends that if a person gets an opportunity for arbitrage, he should grab it. “However, generally, only non-guaranteed investments offer higher interest rates than the prevailing market ones. So investing in a fixed deposit would not offer an opportunity for any kind of arbitrage,” he adds.
Penalty for defaulting
Now let’s assume that you are juggling several loans, but due to a sudden loss of income are unable to pay all your EMIs on time. Here, too, the answer lies in prioritising. Defaulting on some loans results in a bigger penalty than the others, so these loans should be paid off first, irrespective of the interest rates involved.
For instance, defaulting on a personal loan would impact your credit score, but if you default on your car loan, not only will it dent your credit score but there is also the possibility of your vehicle being impounded. Similarly, skipping a single EMI on a home loan is unlikely to drive a bank into a tizzy, but the lender will be a lot less understanding in case of a car or personal loan. The rule of thumb, however, is to inform your bank of your financial situation immediately.
The decision to prepay doesn’t always have to be based on a windfall. It also makes sense to drum up cash to prepay a part of your loan if interest rates jump up significantly, thus hiking your EMI outflow. For example, the interest rate on home loans in 2006 was around 7.5% annually, and today it is around 13%. So you can choose to prepay the balance principal amount to keep the monthly outgo steady without increasing the loan tenure.
However, before doing so, it is imperative that you keep aside some money covering six months’ expenses as an emergency fund. “This should be able to cover bare essentials, such as the monthly loan repayments, utility bill payments, food and other general expenses that you need to keep your life running smoothly,” adding that this fund can also be used in case of any exigencies
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