Given the prices of houses in our country, almost everyone must take a home loan to purchase their dream house.
It is not that all buyers lack the capacity to buy a house out of their own funds. However, from what I have been, as the income (affordability) rises, so does the desire for a better and bigger house. Hence, an increase in income (or improvement in cash flows) merely results in them desiring a more expensive house. The increase in cost could be due to a bigger house, better location, better amenities, or simply appreciation in real estate prices.
However, once you take a loan, there are two drastically different approaches that borrowers tend to take. And a middle path.
#1 Repay as Soon as Possible
Such borrowers want to get rid of the home loan as soon as possible. The reasons are cultural, psychological, or financial.
Such borrowers don’t want to be under any kind of debt. A loan is a burden on their heads. Just the concept of borrowing makes them uncomfortable. Additionally, in our culture, personal debt is seen as bad and looked down upon. Hence, as and when excess funds are available, such borrowers divert funds towards loan prepayment.
And there is a financial reason too. Shorter the loan tenure, the less you pay in terms of interest. You save money.
When you prepay, you reduce the loan tenure. As the loan tenure goes down, you pay less interest over the loan tenure.
For instance, for a home loan of Rs 50 lacs for 25 years, the total EMI outgo (assuming no change in interest and no prepayment) would be Rs 1.26 crores. Removing Rs 50 lacs of principal, Rs 76 lacs goes towards interest payment over 25 years.
Had the loan tenure been 15 years, you would have paid only Rs 41.28 lacs in interest over 15 years.
Hence, by opting for a shorter tenure, you save about 35 lacs. Hence, prepaying your home loan aggressively provides peace of mind and saves on interest.
Yes, you can counter the interest savings part because prepayment amounts could have been invested elsewhere and potentially earn returns higher than the cost of loan.
#2 Keep the Loan Live and Invest Instead
There is a completely opposite school of thought too. Stay in the loan as long as possible and make long-term investments instead of prepayments.
Such investors tend to be more financially aware, perhaps too confident. A home loan is the lowest cost loan available. And the longest tenure. The cost goes down further if you include tax benefits.
Such borrowers think that the long tenure of home loans is ripe for taking risks. Hence, instead of focusing on repaying the loan, they make investments with the hope that they will earn returns higher than the cost of loan. I am not suggesting that the home loan amount is used to make investments. That is not permitted. Instead, such borrowers want to borrow as much as possible.
Borrow more. Pay less from own funds. For them, it is a way to get leverage on their long-term investments. Do note leverage works both ways. Leverage can magnify both gains and losses.
In my opinion, there are more borrowers in Category 1 than in Category 2. However, there is a third category too. The set of borrowers who try to strike balance.
#3 Take the Middle Path
Yes, closing home loan soon is important. At the same time, you do not want to be fixated with home loan closure and neglect other financial goals.
You may start with a big loan amount and continue to pay aggressively until you bring the loan to manageable/comfort levels. The comfort level could be a nominal target or a multiple of your annual income. For instance, your home loan was Rs 1 crore, and your comfort level is Rs 50 lacs. Or you earn Rs 30 lacs per annum, and you will feel comfortable when the loan amount drops to Rs 60 lacs. No sold rationale, just trying to maximize peace of mind. All this while, such borrowers continue to invest for their other financial goals as well.
Once the loan gets to a more comfortable level, the priorities can switch, and more money can flow towards long-term investments.
I am more comfortable with this middle path. This approach is more holistic and allows you to focus on the bigger picture. The outstanding loan amount comes down faster (than without prepayment) and you do not lose sight of your other financial goals.
In fact, there is where home saver loan accounts (e.g. SBI Maxgain) can help. While these come at an additional cost, they allow borrowers a lot of flexibility. For instance, instead of formally prepaying, you just keep adding money to the Overdraft account (or the excess account). You get the benefit of lower interest payments. At the same time, the money is available for use. You can even use these amounts for market investments if an opportunity comes.
There are no right or wrong answers here. Your choice depends on your preferences, and you don’t have to explain the reasons to anyone.
Which category of borrowers do you belong to? Do let us know in the comments section below.