RBI has recently cut the repo rate by 50 bps. If your floating rate home loan is linked to repo rate, your home loan interest rate would have already gone down or would go down in a few months after the next interest rate reset date.
You have just received your bonus. Now that the loan interest rate has gone down, would you use the bonus amount to reduce the loan outstanding? Or would you rather invest in expectation of a higher return?
Rate Cut Makes Your Task Easier
Mathematically, the answer is quite simple. If you expect to earn better post-tax returns on your investment than the post-tax cost of a loan, you are better off investing, else you pay off the loan.
With the rate cut, the threshold return you need to earn also goes down. Thus, everything else being the same, the scale tilts slightly in favour of “Invest” compared to “Prepay”.
Clearly, with the interest rates going down, your threshold return on investment automatically goes down. For instance, ignoring the tax implications, if your loan interest rate was 9% before the repo rate cut, you had to earn more than 9% p.a. After the rate cut of 50 bps, you must beat only 8.5% p.a. Hence, your job has just gotten easier.
However, the investments where returns can beat the cost of loans usually do not offer any return guarantee. Hence, there is risk involved. And from what I have seen, it mostly boils down to the risk appetite of the borrower. The more aggressive and the optimistic borrowers/investors tend to gravitate towards investments, while the conservative investors tend to prefer loan repayment.
But This Is NOT All Just Microsoft Excel
As the debt goes down, it tends to give borrowers greater peace. This alone is a good enough reason to utilize proceeds to prepay the home loan. And there is no way you can model this in a spreadsheet.
Even if you can part prepay the loan, this reduces the EMI or the loan tenure. Again, it is quite comforting to see that your home loan will get over sooner. Even if you opt for a lower EMI, you instantly reduce monthly outgo. Less pressure on cashflows and more money for investments. If you have been running a very tight budget, you will instantly feel the pressure release. These small steps can significantly improve your quality of life. Again, something you can’t model on a spreadsheet.
How Should You Approach This Question?
As I see, there is no one-size-fits-all answer. A borrower’s choice will depend on multiple factors. I am trying to give a rational answer here. However, as we discussed in the previous section,this is not a problem that we can optimize on MS Excel alone. There is an emotional angle involved too. I will leave those parts to you.
#1 Quantum of Debt
If the loan amount is quite big (and given the disparity between the high home prices and the income levels, that is usually the case when you buy a house), it makes sense to bring debt down to more manageable levels.
What is a manageable level of debt? “Manageable” could be a nominal target, say 25 lacs, 50 lacs, 75 lacs etc. OR you can express this as a multiple of your annual income. For instance, you keep repaying aggressively until the loan outstanding goes to say 2X your annual income. OR you can frame this as “EMI is what portion of the take-home-salary?”. So, you might target that the EMI should not be more than say 15-20% of your take-home salary. Any approach is OK.
#2 Prevailing Rate of Interest
Clearly, as mentioned above, the level of interest rate will also play a role. As a borrower/investor, there is a difference between rate cut from 11.5% to 11% and rate cut from 7% to 6.5%. In the first case, the rates are still quite high despite the rate cut. In the second case, the rates indeed look low from the Indian context.
But why is the level of interest rate important? Two reasons.
Firstly, a higher interest rate means you pay more interest. Hence, it is always a good idea to attack high-cost loans.
Secondly, 11% (even after rate cut) is a difficult benchmark to beat than 6.5% p.a. Additionally, the riskier assets (which are alternative to loan prepayment) will likely do better during a low interest-rate regime.
#3 Your Risk Appetite
“Invest vs Prepay” question is moot if you do not have appetite for risky assets and can’t live with the volatility. Safe assets such as bank fixed deposits won’t offer you more than the loan. If you can’t digest volatility, don’t complicate and you should prepay the loan.
#4 Your Financial Goals
This aspect requires consideration too. While you are torn between the dilemma of “invest” or “prepay”, let’s say, your emergency corpus is not sufficient to meet 2 months of monthly expenses. You better shore your emergency reserves first. Additionally, even for long term goals, it may be a decent idea to average your investments in risky assets. Let us assume you receive a very hefty bonus. While you are a risk-taker, putting the entire amount in risky assets is too much for you. You want to put this money gradually into risky assets. You can do that by way of STPs. Alternatively, you can utilise the amount towards loan repayment and request the bank to reduce the EMI instead of the loan tenure. Utilise excess savings towards investments in risky assets.
#5 You Could Invest AND Prepay
It does not have to be an either-or decision. You receive Rs 10 lacs in annual bonus. If you believe, considering your financial planning, Rs 5 lacs towards investments and Rs 5 lacs towards loan repayment looks a healthy compromise, go ahead. There are no right or wrong answers here. Your judgement will play a big role in this choice.
What would you do? Please let us know in the comments section.