Most salaried employees get their annual bonuses in the first quarter of the financial year. Many of us plan to spend it way before we actually receive the bonus. You have to keep up with the commitments that you made to your kids, your spouse, your siblings or your parents. You may have an eye on the latest gadget for a long time. That gadget will be a well deserved reward for the many late-nights in the office during the year. There is nothing wrong in meeting commitments to your family, going for a vacation or spending a portion of your bonus on the fancy gadget. That’s what we work for, right?
However, as always, don’t overdo it. Take a step back. Consider if you can use at least some portion of the annual bonus to improve your long term financial health. For instance, it is not acceptable to use the bonus to purchase the latest phone while you have been struggling to make minimum payments on your credit card. Pay expensive credit card debt first. You may be a very responsible person and may not have credit card debt. However, you may still have housing loan. Should you use your annual bonus to pre-pay housing debt? In my opinion, you should.
You Can Use Your Annual Bonus to Part-Prepay Your Home Loan
Home loan loans are reducing balance loans i.e. a portion of your EMI goes towards interest payment while the remaining goes towards repayment of principal. When you prepay principal (and the EMI remains constant), interest portion of EMI goes down. Thus, a greater portion of EMI goes towards principal repayment.
Any prepayment over and above the mandated EMI can expedite loan repayment and reduce your absolute interest outgo over the loan term. Let’s consider an example. You take a loan of Rs 50 lacs at 9% for 20 years. The EMI is Rs 44,986. Suppose, you get annual bonus the very next day and you decide to prepay the loan with that cash. Let’s assume the bank allows this. You can see even though you prepaid the loan by only Rs 1 lacs, you save over 12 EMIs in repayment. If you have repaid Rs 5 lacs, you would have saved over Rs 24 lacs in interest cost over the long term.
|O/S after Prepayment||5,000,000||4,900,000||4,800,000||4,700,000||4,600,000||4,500,000|
|Loan gets repaid in (months)||240.0||227.2||215.6||204.8||194.9||185.7|
I Do Not Have Such Lump Sum Amount
Even small periodic pre-payments can make a big difference. You may not have such lump sum to prepay loan all the time. However, many times, we tend to ignore the impact of these minor prepayments of our home loan schedule.
Let’s assume you can spare Rs 50,000 from your bonus every year towards home loan prepayment. It may seem like a small amount but with this minor effort, the loan gets repaid in 195 months. You save 45 EMIs. Saving of Rs 20.5 lacs in interest cost. Isn’t that huge?
At Rs 1 lac per annum of prepayment per annum from annual bonus, the loan gets repaid in 167 months and you save Rs 33 lacs over the loan term.
Even at prepayment of Rs 20,000 per year, you save 22 EMIs or Rs 9.5 lacs. Therefore, do not focus on the quantum of annual bonus. Even if you can spare a small amount towards pre-payment, it will have a big effect.
Points to Note
- Only the absolute interest outgo goes down if you prepay the loan. The pre-tax cost of loan does not change. When you make pre-payment, you are effectively making an investment that earns a return equal to the cost of loan.
- When the interest rates go up, the banks do not tinker with the EMI but increase the loan tenure. Prepayment from your annual bonus (or from any other source) is a good way to get your loan tenure back down.
- If you make part prepayment when the interest rates are going down (compared to original contracted rate), the loan will get repaid even faster.
Pay the Most Expensive Debt First
Even though this post is focused around home loans, if you have multiple loans, consider prepaying the most expensive debt first. Clearly, attack the loan with the highest interest rate. Credit card debt is the most expensive. The interest cost can easily be in excess of 40% p.a. Then, there are personal loans with interest cost between 12-15% p.a. For instance, if you have been making minimum payments on your credit card, you must repay credit card debt first. Home loan can wait. There are a few other aspects such as pre-payment penalty and tax-benefits of loans that you must consider. I have discussed this aspect in detail in another post.
Tax Benefits Are Overhyped
Many of us refrain from pre-paying our home loans because of the tax benefits for interest payment (under Section 24) and principal repayment (under Section 80C). In my opinion, the tax-benefits on home loan are overhyped.
For instance, in the above example (Rs 50 lacs, 9%, 20 years), you are paying interest of Rs 4.46 lacs in the first year. This is way more than tax benefit of Rs 2 lacs that you get from interest payment under Section 24. For any interest that you pay above Rs 2 lacs during the year, there is no tax benefit. Therefore, if the loan outstanding is quite high, it is better to prepay a part of the home loan.
When the loan outstanding is quite low, it may make sense to continue with the loan and not pre-pay the loan. Even with that, you also need to see if the investment (you made by not prepaying the loan) earns you a better post-tax return. Let’s suppose the post-tax cost of your loan is 6% (well, you are getting benefits for principal repayment too). However, if the post tax return from your fixed deposit is only 5%, it is better to prepay the loan irrespective of the outstanding loan amount. It is another matter if you decide to invest in another investment that earns you better post-tax returns. At the same time, do not focus solely on home loan repayment.