Prepaying a loan is usually a good idea. And, part-prepaying the principal part of the loan makes even more sense.
The reason is that it reduces the total amount of interest you have to pay out and, possibly, the loan tenure. But before doing so, you must look at some factors.
Opportunity Cost
To get that, calculate the net rate at which you are paying interest after accounting for tax breaks. Typically, if you are repaying a home loan on a self-occupied house, you get a deduction from your income up to Rs 1.50 lakh (Rs 150,000) a year in interest; on a house that is not self-occupied, you can claim the full interest outgo; and the same for a study loan.
Unless you are self-employed, you do not get a break on your car loan. If you are, you can claim the interest part of your EMIs as deduction from income.
Your tax break will vary with the tax slab you are in. Netting it out, you can find the effective rate at which you are paying interest.
On a home loan of Rs 15 lakh (Rs 1.5 million) at an interest rate of 10.25 per cent for a term of 15 years, the effective rate of interest for someone paying 30.9 per cent tax becomes 9.03 per cent, a reduction of 1.22 percentage points.
In the same way, check out the net return you are earning, or realistically expect to earn on the funds that you would use for prepayment. You need to take into account taxes. This, too, will depend on your tax slab.
If the net return on your investments is lower than the net rate of interest you are paying, then the decision to repay the loan principal, in part or whole, is obvious. Go for it.
Other factors
Things, however, get a bit tricky in the reverse, if less common, situation. Let us first look at the total outgo on, say, home loans.
If you had borrowed at 7.50 per cent in 2004, in some cases you would now be paying more than 17 per cent. That has more than doubled the total interest outgo, increased your EMI, or loan tenure, or both.
The effect was less dramatic on car, or study loans. You are unlikely to have budgeted for this huge leap. So, to bring things back under control, it makes sense to prepay.
Interest rates are falling
Even so, the average person does not like too much of financial uncertainty. While he was less worried about repaying loans when the economy was growing, it's not so any more. What if he lost his job? That solves it for most. Broadly, loans should be prepaid to the extent possible.
Also, as the inflation rate declines, unless the interest payout declines in tandem, the difference between the two keeps increasing. This difference is the real rate of interest. It is low when inflation is high, and vice-versa. So, it is better to borrow when inflation is high and repay when it is falling, especially for those on fixed rate loans.
Prepayment Sequence
Satyam Darmora, 29, a Gurgaon-based financial analyst, for instance, has both a car and home loan and wants to figure out which one to pay off first.
Apnaloan.com CEO Harsh Roongta says: "Home loans give tax deductible benefits, while car loans don't. So, one must prepay the car loan first. However, as a rule of thumb, one must keep six months' expenses as emergency funds. Once this is taken care of, prepay debts. Car loans are on an average of 5-year tenure, but a home loan has a longer tenure. In the longer tenure, expect interest rates to fluctuate. In the present scenario, it's most likely that interest will go down."
Jai Ganesh, a management trainee in Chennai is wondering whether he should prepay his study loan. The answer remains yes.
Study loans usually fall somewhere between car and home loans -- in terms of tenure and interest rates. So, it is in the middle in the sequence of prepayment too.
Zankhana Shah, certified financial planner and head of Moneycare Financial Planning, Mumbai, says: "It's better to take another loan at a lower fixed interest rate, and pay off the existing education loan."
Need A Car? Buy It
Says Shah: "Auto loan rates may go down soon. Prices already have. So, it would be good to buy in the near future." Roongta suggests taking a car loan on fixed rates. It also pays to keep looking for better deals.
What to do
- Before prepaying a loan, look at what the money can earn from other investments
- If your return is less than the rate of interest on your loan, then prepay
- Prepay car loan first, next education loan and then home loan
Quick Fix
During this slowdown, how much emergency cash should one have?
One should have the expenses for 3-6 months, depending on how much you perceive your income flow to be at risk. That should normally be enough to tide you over a crisis, provided you have your insurance policies in place.
How safe are my FDs in an NBFC, which give better returns than banks?
Protection of deposits up to Rs 1 lakh (Rs 00,000) by a single person in a scheduled commercial bank is guaranteed. Even if the amount is larger, you are, for all practical purposes, secure. Global Trust Bank went under in 2004, but was absorbed by Oriental Bank of Commerce and depositors were protected.
That won't happen for NBFCs if depositors lose money. The higher return you get is actually the risk premium paid to attract deposits.
