March 1, 2017 No Comment. Posted in Financial Literacy

It is an interesting irony with Home Loans. Till the time a person does not have a home loan, he aspires to take one as soon as possible in order to purchase a home. Once he has taken a home loan, the first priority in his life becomes to repay his home loan even though it may come with a cost of his reduced standard of living.

It is a prudent decision to repay a loan if one does not require it. After all why should you pay interest on a loan costing roughly 10% when you have idle funds sitting in your bank account account earning just 4% interest?

prepayment is the repayment  of a debt or instalment payment before its official due date. A prepayment can either be made for the entire balance of a loan or for a part payment that is paid in advance of the date for which the borrower is contractually obligated to pay.

We may note that there are no charges applicable on the prepayment of home loan if purchased in Individual capacity. But if the is purchased in the capacity of business entity, there would be pre-payment charges levied in case we want to part or full pre-pay the loan. Though most of the bank don’t charge any penalty if the advance part payment is made in tune of up to 25% of the principal outstanding in the financial year.

There are a group of thinkers who do not believe in the philosophy of repaying back their home loans. Let’s discuss the pros and cons of repaying a home loan and it will be up to you to decide which of the best option suitable for you is.

Reduction of Interest paid on the principal outstanding

 

The most obvious benefit out of prepayment is that your interest payout reduces. Prepayment of home loan results in an immediate reduction of the outstanding principal on the home loan which results in less interest being accrued on the loan account. For example, if you have a principal outstanding loan of Rs. 10 lacs at 10% interest, you would be annually paying approx Rs. 1 lacs interest. If you prepay the loan by Rs. 1lacs, your interest would reduce from Rs. 1 lacs to Rs. 90000 per year – approx 10000 saving per year for the duration of the loan.

 

Prepayment of loan by giving the impact on the loan tenure

 

Generally when you are going to prepay your home loan, you have two options. Either you can reduce the number of home loan instalments or keep the number of instalments same but reduce the monthly mortgage payments (EMIs). For example, if you prepay your home loan by Rs. 100,000, you may be provided two options:

a) Instead of paying your monthly EMI (e.g. Rs. 10000 per month ) for original tenure of 120 months, reduce the tenure of the same monthly EMI of Rs. 10000 to 110 months (illustrative)

OR

b) Keeping the original number of EMIs the same, e.g. 120 months, but reduce the monthly EMI payment from Rs. 10000 to Rs. 9500, i.e. a reduction of Rs. 500 per month in monthly cash outflow.

If you want to improve your monthly cash flows by a reducing per month cash outflow by way of EMI and easing the family budgets then option “b” is advisable. But if you want to finish off your loan/EMI and comfortable with the existing monthly outflow of EMI, option “a” is most advisable.

It should be noted that ‘Longer the tenor of the loan, though the EMI amount  would be less but the total Interest paid over the entire loan term would be more as compared with the loan of shorter tenor irrespective of what rate of Interest is offered to you.

Impact on Leverage

This is an interesting topic and in order to understand it lets take an example. Mr Sharma has an investment opportunity which requires Rs. 1 lac investment and it would provide him annually 15% return. His annual return in this case is Rs. 15,000.

Now let’s bring in another situation, say Mr Sharma has just Rs. 20000 in his pocket and he still has the same investment opportunity. Mr Sharma goes to a bank and takes a loan of Rs. 80000 at 10% interest.

 

His situation after end of the year would look like :

His investment – Rs. 20000 and Loan to pay Rs. 80000.

Total Income from the investment (Rs. 1 lac @ 15%)         – Rs. 15,000

Less Interest paid on Loan (Rs. 80K@10%)                          – (Rs .8,000)

Net Income for Mr Sharma                                                        – Rs. 7,000

Return for Mr Sharma on his investment of Rs. 20000 = (7000/20000) x 100 = 35%.

The example above tried to show how leveraging work. Just like a normal Lever is used to multiply the effort to lift heavy loads, financial levers use loans to multiple your returns , if used correctly.  Generally if the interest rate paid out is less than the return earned from your investment, you would gain from taking a loan.

In case of a home loan, if you perceive that your property is going to give you a return of more than home loan interest rate, you would perhaps be better off not paying your home loan. This is just a general statement and each case would need a specific analysis.

Debt Equity Ratio 

This is one of the classic financial ratios and perhaps one of the first ratios looked into by analysts to identify how risky a financial decision is and hence determining the respective financing cost (interest rate). It works opposite to the Leverage example above. While leveraging mentions that the more your loan is, the better would be your net returns. However, the contrary aspect associated with it is – the more loan you have (in % terms), the more risky your investment become to the lenders. For example:-

Mr Gupta has a property valued Rs. 10 lacs of which only 1 lacs has been paid by Mr Gupta from his pocket and remaining 9 lacs (90%)has been taken on loan. Mr Gupta hence has debt equity ratio of 9:1.

Mr Aggarwal has a property valued Rs. 10 lacs of which his contribution is Rs. 3 lacs and remaining 7 lacs (70%) has been financed via a loan. Mr Aggarwal has debt equity ratio of 7:3

If for examples real estate markets tank by 10% and the properties are now valued at 9 lac each, Guptaji stake would be reduced to zero and Mr Aggarwal stake would be reduced to Rs. 2 lacs. If you are a financer giving a loan to Mr Gupta/Mr Aggarwal, you would rather want to avoid financing Mr Gupta as he is heavily leveraged and hence a more risky investor than Mr Aggarwal.

In this example, Mr Gupta may walk away as he would not have any incentive to hold his property (considering it is less than the value he purchased and his entire investment has been wiped out). On the contrary, Mr Aggarwal would still be inclined to hold on to the property considering he has still 2 lacs of this investment in the property. Hence, even if the bank would want to finance Mr Gupta, they would charge a higher interest rate for the extra risk in that decision.

The reason for the explanation above is that, you may want to prepay your home loan to bring it within a comfortable debt equity ratio. Ideally this ratio is 7:3 to 8:2 i.e. Loan to Value of your property is 70%-80%. Banks in many cases provide a better interest rate deal if the Loan to Value is lower than 75%.

Use Mortgage as an Overdraft Account

This is one of the least used options available in the market. Outside India, the product is generally called as an Offset mortgage. In India, the product is home saver or drop line over draft (DOD).  In this type of mortgage account, if you have surplus funds, you can deposit the funds in your bank / mortgage account and interest shall be computed on the balance mortgage loan. You are free to withdraw the deposit and the interest shall levied on the remaining balance.

 

Hence, whenever you have surplus funds, you reduce your interest payouts. If you find an investment opportunity, you can withdraw the funds from your mortgage to fund your investments. By this way, you tend to get a good mix of putting surplus funds into work (by reducing interest payouts) and at the same time having the flexibility to get the funds back when needed. It is important to note that any deposits made in such an account do not end up reducing your mortgage balance permanently. The excess funds temporarily suspend interest accruals on the deposited amount till such a time these funds are not withdrawn by the account holder.

Conclusion

In line with above mentioned details, you may want to revisit your current home loans / mortgages and analyse which side of the fence you are sitting. You may have a very high leverage and sitting on excess cash – probably a good idea to repay a bit of your loan. Alternatively, you have paid a good part of your loan and hence you may want to invest your excess cash in other investment options to avoid reducing the impact of leverage on your home investment decision.