Question 1: Interest rates have gone down. I want to buy a house. While I can fund the purchase with own funds, I think taking a home loan is a good idea since the interest rates are low. I can earn a higher return than the loan interest rate on my investments. Plus, I will get tax benefit for home loan repayment.
OR
Question 2: Interest rates have gone down. I have some funds with me. But I think it may not be a good time to prepay the loan since the interest rates are already low. I can generate better returns through investments.
Such questions have become quite common, at least from my investors, since the loan interest rates are at multi-year lows. While such questions can take many forms, it remains nothing more than an “Invest or Prepay” decision.
The thought process is simple. If you can earn a post-tax return on your investment that is higher than the post-tax cost of your loan, then you take a loan for your expense (house purchase) and invest your own funds. Or else, you use your money to purchase the asset or prepay the loan. Is it easy or difficult?
What do you think? While this might look easy since the loan interest rates are low, is it really that easy?
How Would You Earn a Higher Rate of Return Than Your Loan Interest Rate?
It is unlikely that your bank would offer a fixed deposit at 8% and give you a loan at 7% per annum. Such a bank would go bust soon, wouldn’t it?
While loan interest rates are multi-year lows, the bank fixed deposit rates are at multi-year lows too. Note the banks are merely intermediaries. They accept deposits from one hand and dole out loans from the other. Hence, the borrowing and the lending rates can’t be completely unrelated.
In that case, how do you generate returns that are higher than the cost of your loan?
You will have to take some risk. And risk is a double-edged sword. Higher risk does not guarantee higher returns. If it did, you wouldn’t call such an investment risky, would you? You can earn a high return but there is risk of poor return too. Let’s look at some of the investment options.
You can invest in corporate fixed deposits or Non-convertible debentures. Not without risk. There is risk of capital loss. Spare a thought for investors in DHFL FDs and NCDs. And the complete disaster for AT1 bond holders of Yes Bank (investors lost the entire investment). Under appreciating risk in an investment is the biggest mistake you can make. When the times are good, you can’t see how things can go wrong with a particular investment. When things go wrong, you can’t figure how to exit or minimize losses.
OR
You can invest in debt funds. However, ultimately these products will invest in bonds that may carry credit risk.
With fixed income products, higher return comes through higher risk. The only exception perhaps is small savings schemes (PPF, SSY, SCSS). Add VPF to that list. But there are limitations in terms of who can invest and how much you can invest.
OR
You can invest in even riskier products such as equity or gold. We have been constantly fed that equities give better returns over the long term. Nifty 50 has given 7.01% p.a. CAGR since the beginning of this decade (from January 1, 2011 until October 23, 2020). You would have done better with a bank fixed deposit. This is not to say equities are bad investments. This decade has been bad for Indian equities. The previous decade was awesome. The next might be awesome too. However, this notion that you can’t go wrong with equities over the long term is misplaced. Even SIPs do not guarantee good returns.
What Should You Do?
The gist of the discussion above is:
The interest rate on the loan is fixed (or floating) must be paid. There is no guarantee that you will earn a higher rate of return on your investment.
I am not saying that you must not take a home loan and simply use your funds to make a big purchase. All I am saying is do not make low or high loan interest rates a big deal in this decision. As the loan interest rates go down, the incremental returns from at least your fixed income investments will also go down. By the way, high or low interest rates can affect your affordability as the EMI depends on the loan interest rate.
What should you do then? I don’t have a crisp answer. My answer (whether you should take the loan and how much) can vary depending on your age, purchase cost, existing wealth, cashflows, risk profile and other case specifics.
By the way, you should also not look at everything from the returns angle. Explore the situation from your overall financial planning angle. For instance, you want to buy a house that has an all-in cost of Rs 50 lacs. Your total assets are Rs 50 lacs. Even if you want to buy the house through your funds, you can’t possibly use all your wealth to buy the house. If nothing else, you need money for contingencies. You will have to take a loan.
Take a holistic view of your finances. There will be tax considerations too. If the quantum of loan is not very big, the post-tax cost of loan will also be low because of tax benefits (you may get tax benefit on the entire interest paid). You must look at EMI affordability. Perhaps, you can use your money to the extent that the loan EMI is comfortable.