You have Rs 4 lacs in your bank account. You have 3 loans running and a bit of credit card debt.
- Home loan of Rs 20 lacs (Remaining Tenure: 17 years, Rate: 8% p.a., EMI: Rs 18,000)
- Personal loan of 5 lacs (Remaining Tenure: 3 years, Rate: 13% p.a., EMI: Rs 17,000)
- Personal Loan: Rs 59,000 (Remaining Tenure: 8 months, Rate: 16% p.a., EMI: ~ Rs 8,000)
- Credit Card outstanding of Rs 27,000
What would you do? Retain cash in the bank OR prepay expensive loans? The choice is simple, isn’t it? Just pay off the high interest cost loans. Therefore, pay off the credit card debt and personal loan of 59,000. And reduce outstanding in Rs 5 lac loan. Retain the home loan since the interest cost is low and you also get tax benefit.
Well, not always. In personal finance, the context changes everything.
Let us fill in a few details. The Covid pandemic has been harsh on you. You have lost your job and are still trying a find a new one. Clearly, the cash inflows in the near future seem uncertain. You got this Rs 4 lacs from a few friends who offered to help.
What do you think you really need in such a case? Optimization or a longer rope?
If you are looking for optimization, prepaying an expensive loan is an excellent choice.
However, if you are looking for a longer rope, then conserving cash may be a better choice. Rather than square off the loans, you can simply continue with the EMIs and let them close naturally, at least until you find a new job.
Doing Math for Various What-if Scenarios
Let’s assume, in all the scenarios, we will square off the credit card debt. We do this because the amount is small and seems manageable (again contextual). Additionally, credit card debt is just too expensive. High interest and various penalties would compound the outstanding very fast.
We are left with Rs 4 lacs – Rs 27,000 = Rs 3.73 lacs.
We are left with 3 loans now.
We won’t prepay the home loan either. The interest rate is low, and you get tax benefits too.
So, we are left with Rs 3.73 lacs and two personal loans.
We do not pay off any of the loans.
Total EMI = Rs 18,000 (home loan) + 17,000 (personal loan 1) + 8,000 (personal loan 2) = 43,000
Your monthly expenses are Rs 25,000.
Total monthly outgo = 43,000 + 25,000 = 68,000
So, we have cash for Rs 3.73 lacs / 68,000 = 5.5 months
You pay off the personal loan (2) of Rs 59,000. Your cash is down to Rs 3.14 lacs, but there is one less EMI to pay.
Total EMI = Rs 18,000 (home loan) + Rs 17,000 (personal loan 1) = Rs 35,000.
Total monthly expenses = Rs 35,000 + Rs 25,000 = Rs 60,000
You have cash for Rs 3.14 lacs / 60,000 = 5.23 months
Not much difference from Scenario 1. You have cash for 1 week less (though you will have a lower loan liability at the end of the period). This is still fine.
You pay off the personal loan (2) of Rs 59,000. Additionally, you pay Rs 2 lacs of personal loan 1. Further, you request the bank to reduce the EMI. Note that the default mode is reduction in tenure (and not in EMI).
EMI for personal loan goes down from Rs 17,000 to Rs 10,108. Awesome.
Your cash position goes down to Rs 1.14 lacs.
Total EMI = Rs 18,000 (home loan) + Rs 10,108 (personal loan1) = Rs 28,108. Awesome again.
Total monthly outgo = Rs 28,108 + 25,000 (regular expenses) = Rs 53,108
Now, you have cash for Rs 1.14 lacs / 53,108 = 2.15 months
You can see, in Scenarios and 2 and 3, you have lower loan outstanding and lower EMIs than Scenario 1. At the same time, you have a shorter rope too.
In scenario 3, you will run out of cash in just a couple of months. If you don’t find a job by then, how will you manage your monthly expenses? And you will default on your loan EMIs after this period too. Yes, Scenarios 2 and 3 seem more optimal since you are paying off expensive loans. However, for a person who is still seeking a job, Scenario 1 may be a better choice. In such cases, you need a longer rope. By the way, Scenario 2 is not too bad either.
There Could Be Friction
Personal loans prepayment usually involves a penalty. And an expensive personal loan will likely have a higher prepayment penalty.
Let’s assume the Rs 59,000 personal loan had a prepayment penalty of 4% of the prepayment amount. Hence, if you foreclose the loan, you will have to pay a penalty of Rs 2,784 (incl. GST).
Total outgo for prepayment = Rs 59,000 + Rs 2,784 = Rs 61,784
Had you simply continued with the EMIs, you would have paid a total of Rs 62,594 over the next 8 months. Hence, you do not really save much on the cashflow front.
And Things Can Go Wrong
In the above illustrations, we did these calculations on excel. What about unplanned expenses? What if you must spend Rs 50,000 on medical treatment? This reduces the cash buffer by a few weeks. What if you had the buffer only for 8 weeks (Scenario 3)? Complicates matters even further. Remember it is not easy to get fresh loans when you are out of job. In such a specific case, a bigger cash buffer (not prepaying loans) buys you time to find a job and handle unplanned expenses.
Finally, What Should You Do?
There is no right or wrong answer. And we don’t have to go with just one approach (no prepayment or full prepayment). We could use a mix and match approach. As I said, everything depends on the context. Your cash flow position, quantum of cash and loan outstanding, expenses etc. However, now we know that, at least in a few cases, retaining cash might be better than prepaying a loan at 13 or 15% p.a.