This article has been penned as a result of a reader question:
My MF has given some good returns. Shall I book some profits to make a prepayment of my home loan? Or Let the home loan run its course along with my investment for Goals. How to decide between prepayment of Home loan vs Investing in MF for goals? - Mr. K
This article introduces the concept of home loan prepayment and should be referred to before understanding this one.
Strategies for prepaying: Steady prepayment
We will assume a ₹ 50 lakhs loan taken at 8% for 25 years. The EMI of this loan will be ₹ 37,671. We test the following strategies:
Case 1: Normal case: fixed EMI paid over 25 years
Case 2: One extra EMI paid at the end of every year
Case 3: EMI increased by 5% per year
(click to open in a new tab)
Cases
Normal EMI
One extra EMI yearly
5% increasing EMI yearly
Interest paid (lakhs)
₹ 63.0
₹ 49.4
₹ 35.8
Loan repaid in
300 months
244 months
164 months
Portfolio (lakhs)
₹ 1,089
₹ 1,089
₹ 1,088
We will consider these scenarios vs a SIP investment increasing at 5% per year in equity (11% return post-tax) and debt (3% return post-tax) mutual funds. The portfolio is rebalanced yearly to maintain a 60:40 allocation to equity and debt, respectively. This example alludes more to investors with a unified portfolio but is also applicable to more general cases.
We assume that the investor has ₹ 100,000 per month, of which ₹ 37,671 goes to the home loan, and whatever is remaining is invested. When the EMI increases or prepayment is done, a lesser amount is available for investing that month. However, once the loan is paid off, the entire amount is available for investing for a total of 25 years:
(click to open in a new tab)
The portfolio row in the table above shows the value of investing after 25 years in all the cases. As you can see that the difference in the final portfolios is minuscule.
The difference between investing and prepayment is low since the loan rate is close to the portfolio’s blended return, the opportunity cost. This means that whenever prepayment is done, it happens in a portfolio whose target interest rate is very close to the home loan.
However, a closer look at the chart of loan balance vs portfolio growth shows a substantial difference in the prepayment cases when the loans are paid off earlier. This is because accelerated EMIs divert more money to the loan than investments. If you are investing for 25 years, it evens out. The cases are highlighted in red circles:
Case 2 vs Case 1: ₹ 620 lakhs vs ₹ 637 lakhs in 244 months
Case 3 vs Case 1: ₹ 238 lakhs vs ₹ 273 lakhs in 162 months
Hence, if you steadily prepay your home loan, you will not be worse off over a long time. As an added benefit, you can enjoy being debt-free earlier.
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Strategies for prepaying: Lump sum prepayment
Consider that the investor has a lump sum amount either from a bonus at work or from another source. Even rebalancing from equity when equity markets have gone up significantly is another reason for this lump sum. This is to be evaluated in the context of the investor’s entire portfolio. The amount should go where it has the most chances of meeting future financial goals. The home loan should be considered as a debt investment which
has a lock-in (like PPF) up to the time the loan is fully paid off
has a reasonably high (compared to other debt instruments) and guaranteed interest rate (that will be slightly lower than the rate shown by the lender due to tax deduction on home loan interest)
Perform a recalculation of your entire portfolio using a comprehensive planner (like this) to see where this allocation should be made to debt or equity. If the allocation comes to debt, then prepay the loan with that amount. Keep in mind that unless you have a home loan like SBI Maxgain, the money you have invested into the loan cannot be brought out. It is generally a one-way transfer.
You should not prepay the home loan if your asset allocation does not allow it. For example, this may happen if the portfolio is already debt-heavy or the goals are such that the portfolio cannot be rebalanced further into debt.
Behavioural aspects of rebalancing vs the feeling of being debt-free
Once you recalculate your asset allocation, you need to decide how much rebalancing you wish to do. For example, some investors are concerned about tax implications when they sell. However, if the market moves suddenly, and falls are sharper and more sudden than rises, there will be many regrets. Ultimately you need to minimize your regrets by considering which of the following scenarios is most preferable (not most likely)
We will consider the following cases:
the market goes up after you rebalance from equity to debt
the market goes down, and you did not rebalance
the home loan rate falls after you prepay
You need to balance the regret in the cases above vs the feeling of being debt-free earlier.
Ideally, you should bring the equity to debt ratio to the exact value as required by your asset allocation. This is specifically true if you have a unified portfolio since the risk profile of such a portfolio is higher than non-unified portfolios. You should trigger rebalancing once it has gone beyond a corridor value of, say, 5%. So if your target allocation is 60:40, you should rebalance at 65:35 or 55:45.
The rebalancing from equity to debt and cash as shown to debt and cash buckets. The investment to the debt bucket can be invested in the home loan by prepaying.
The bank doesn’t want you to prepay
Any lender would wish for the loan to be serviced until the end of the tenure. This way, their income from interest payments on the loan continues predictably. To enforce this, many banks have a prepayment clause. If you close the loan before the tenure is up, you need to pay the penalty to the bank. You should check with both your home loan provider and RBI regulations to know what prepayment penalty, if any, applies to you.
If you are prepaying the loan, ensure that it is immediately applied to the principal amount and the duration comes down.
Reviewing your loan regularly
You should, as a part of your regular portfolio review, look at your home loan at least once in six months. You should check if
Can you lower the rate by switching to another lender?
Can you change to RLLR based loan vs base rate loans?
Can you change to a SBI Maxgain type loan which you can use to store a part of your emergency fund?
If you are getting a better rate elsewhere, consider switching costs and customer service of the new lender.
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This post titled Should you use your stock market profits to prepay a home loan? first appeared on 28 Sep 2021 at https://arthgyaan.com
