You got your annual bonus. You have a home loan too. What should you do?

- Use the bonus (lumpsum) amount to repay the loan OR
- Invest the amount in the hope that you will earn a higher post-tax return than the post-tax cost of home loan

There is no black and white answer. My stance has been that you should try to bring the outstanding loan amount to comfortable levels by making prepayments. Once the home loan amount is comfortable, you can choose depending on your preference and risk appetite. “Comfortable” is subjective.

Additionally, you must pay the loan installment but there is no guarantee of good returns from your investments. Many investors underappreciate risk and make insipid choices with their investments. Equity investments go through ups and downs. And then there is own behaviour to manage. You might make a good investment but exit at a wrong time.

On the other hand, home loan repayment is a simple choice. While this is not the most rational choice, seeing the outstanding loan amount come down would make most people comfortable.

However, with the assumption that you will not make bad investment choices and not be worried by volatility, how would this decision look? Or in other words, if you had invested the bonus/lumpsum and not repaid the loan, how would those decisions have looked in hindsight? What does the data tell us? Let’s find out.

## How Do You Decide if You Did Better by Investing?

Let us assume, instead of making the loan prepayment, **you invested the amount in Nifty 50.** And you revisit the choice after a period. **Did you earn better returns than the cost of the loan?**We could look at 3-year and 5-year returns. If your investment in Nifty 50 fetches higher returns than cost of loan, you would be happy. However, you would make those investments (instead of prepayment) on different dates. So, we can’t just pick up any date for this analysis.

That’s right. We can address this concern by looking at rolling returns data. **A rolling returns chart is simply a plot of point-to-point returns for a lookback period.**

The plot for 1-year rolling return on Jan 25, 2021, will be return over the previous 12 months (from January 26, 2020, until January 25, 2021). Or point-to-point return from January 26, 2021, until January 25, 2021). You plot this return for all the dates. You get 1-year rolling returns chart. **You can also average the rolling returns data to get the average 1-year rolling returns.**

Similarly, to plot a 3-year rolling returns chart, the look-back period is 3 years. For the plot point for January 25, 2021, we look at the return from January 26, 2018, until January 25, 2021. **Looking at rolling returns is a good way to eliminate start date and end date bias.**

## Which Option Is “Better”?

How do you decide if you have done better? We can look at the rolling returns chart or average rolling returns and see if the investment has done better than the cost of loan. But there is a problem. What do we take for the cost of loan during the period?

- Home loan interest rates have come down since late 90s. Just look at this data from the State Bank of India. Home loan interest rates until 1990s were easily above 15%. Ranged from 10% to 15% during 2000-2010. Only for a brief period in 2003-2004) did interest rates fell between 8.5%-10% p.a. Until 2015, the home loan interest rates will still close to 9-10%. Hence, the recent sub-8% p.a. home loan interest rate is rather novel for Indian investors.
- I have considered data only for SBI and perhaps this data is for their best borrowers. Other banks/HFCs could have offered vastly different interest rates. Even SBI could have asked more from its less creditworthy investors.
- Then, the home loan interest rate is not constant.
- Post-tax cost of loan can be different for different borrowers. For a borrower in 30% tax bracket, the effective cost of 10% loan would be 7%. For a borrower in 5% tax bracket, the effective cost of 10% loan would be 9.5% p.a.
- Not just that, the tax benefit of interest payment for a housing loan is capped at Rs 2 lacs (for a self-occupied property). So, if the loan is at 8%, just Rs 25 lacs loan would maximize the tax benefits. Excess interest payment does not get you any tax benefit. For excess amount, pre-tax cost remains post-tax cost of loan.
- You can get a higher tax benefit for interest payment for a let-out property (and not self-occupied property).

You can see this is complicated.

LTCG on equity has been exempt from tax for a considerable period (from 2004 until early 2018). Now, there is 10% tax on LTCG.

## How to Decide the Winner?

Let’s make a few assumptions.

- The amount under question (for repayment or investing) won’t affect your tax-benefits if you use the amount for home loan repayment. For instance, for a self-occupied property, the excess principal amount over 25 lacs (assuming 8% rate of interest) does not fetch you any tax benefit for home loan repayment. By making the repayment, you do not bring the loan amount under Rs 25 lacs.
**Hence, the cost of loan to compare against returns from equity is the pre-tax cost of loan (or the actual loan interest rate).** - If your post-tax cost of loan is lower than your loan interest rate, you can view the analysis accordingly.
- LTCG on sale of equity/equity funds (in excess of 1 lac per annum) is taxed at 10% per annum. This reduces your realized returns from equity.
- We do not indulge in market-timing or look at valuations to invest. As and when the money is available, it is invested.

Now, how to decide the winner.

- Equity returns should be comfortably higher than the cost of loan. After all, the risk must be worth it.
**Nifty 50 must have beaten the loan interest rate 70% of the time. You can choose a different threshold.**- For 2001-2010, the home loan interest rates ranged from 10-15% p.a. So, 15% is safe. Between 12% and 15% is OK. Below 12% is not good.
- For 2011-2020, the rates have ranged from 8-10%. So, more than 12% is good. Above 10% is OK. If you get less than 10%, it is not worth it.

## 3-Year Rolling Returns

| ||||||||

Less than 0% | Between 0% and 5% | Between 5% and 8% | Between 8% and 10% | Between 10% and 12% | Between 12% and 15% | Greater than 15% | Total/Averages | |

1999-2021 | ||||||||

Total No. observations | 382 | 489 | 534 | 435 | 480 | 663 | 1,753 | 4,736 |

Percentage Time spent | 8.1% | 10.3% | 11.3% | 9.2% | 10.1% | 14.0% | 37.0% | 100% |

Average Rolling return | -7.24% | 2.70% | 6.46% | 9.08% | 10.96% | 13.38% | 28.84% | 14.92% |

2001-2010 | ||||||||

Total No. observations | 70 | 350 | 341 | 155 | 116 | 180 | 1286 | 2,498 |

Percentage Time spent | 2.8% | 14.0% | 13.7% | 6.2% | 4.6% | 7.2% | 51.5% | 100% |

Average Rolling return | -1.8% | 2.8% | 6.4% | 9.0% | 10.5% | 13.0% | 32.7% | 20.05% |

2011-2020 | ||||||||

Total No. observations | 21 | 117 | 185 | 273 | 332 | 471 | 460 | 1,859 |

Percentage Time spent | 1.1% | 6.3% | 10.0% | 14.7% | 17.9% | 25.3% | 24.7% | 100% |

Average Rolling return | -1.6% | 2.6% | 6.6% | 9.1% | 11.0% | 13.6% | 18.2% | 12.05% |

While building up this table, I have considered the data for investments made in this period. For instance, the 3-year rolling returns data for 2001-2010 considers investments made between January 1, 2001, and December 31, 2010. For this, I have picked data for January 1, 2004, and December 31, 2013, from the rolling returns plot.

**2001-2010:**

Nifty 50 TRI 3-year rolling return exceeds 15% p.a. only 51.5% of the time.

>12%: 58.7% of the time

The loan interest rates during the decade ranged from 10-15% for most part. You would have wanted at least better than 12 p.a.

**2011-2020:**

>12%: 50% of the time

>10%: 67.9% of the time

The interest rates during this period were 8.5%-10% p.a.

So, you would want to earn at least 10% for the risk to be worthwhile.

**In neither of the decades, do we cross our threshold of 70% (remember this threshold is artificial. You can choose a different threshold).**

By the way, note the difference in average 3-year rolling returns in the two decades. In 2001-2010, you earned 20% p.a. In 2011-2020, you earned 12.05% p.a.

## 5-Year Rolling Returns

You are a long-term investor and want to compare against 5-year rolling returns.

5-Year Rolling Returns | ||||||||

Less than 0% | Between 0% and 5% | Between 5% and 8% | Between 8% and 10% | Between 10% and 12% | Between 12% and 15% | Greater than 15% | Total/Averages | |

1999-2021 | ||||||||

Total No. observations | 4 | 284 | 603 | 450 | 389 | 959 | 1,551 | 4,240 |

Percentage Time spent | 0.1% | 6.7% | 14.2% | 10.6% | 9.2% | 22.6% | 36.6% | 100% |

Average Rolling return | -0.40% | 3.19% | 6.50% | 8.98% | 11.10% | 13.42% | 25.50% | 15.47% |

2001-2010 | ||||||||

Total No. observations | 2 | 219 | 266 | 143 | 226 | 321 | 1321 | 2,498 |

Percentage Time spent | 0.1% | 8.8% | 10.6% | 5.7% | 9.0% | 12.9% | 52.9% | 100% |

Average Rolling return | 0.0% | 3.2% | 7.1% | 9.0% | 11.1% | 13.3% | 26.7% | 18.38% |

2011-2020 | ||||||||

Total No. observations | 2 | 52 | 202 | 217 | 138 | 594 | 158 | 1,363 |

Percentage Time spent | 0.1% | 3.8% | 14.8% | 15.9% | 10.1% | 43.6% | 11.6% | 100.0% |

Average Rolling return | -0.8% | 2.8% | 5.9% | 9.0% | 11.1% | 13.5% | 18.8% | 11.60% |

**2001-2010:**

Nifty 50 TRI 5-year rolling return exceeds 15% p.a. only 52.9% of the time.

>12%: 64.8% of the time

The loan interest rates during the decade ranged from 10-15% for most part. You would have wanted at least better than 12 p.a.

**2011-2020:**

>12%: 54.2% of the time

>10%: 64.3% of the time

The interest rates during this period were 8.5%-10% p.a.

So, you would want to earn at least 10% for the risk to be worthwhile.

**Again, lower than the threshold of 70% for either decade. Note that the threshold of 70% is artificial.**

## What Does This Mean?

The argument for investing is not very convincing. There is no overwhelming evidence (subjective) that investment (instead of prepayment) would have been a better choice.** I am sure there are investors who would have made it work for them.** However, for normal investors like you and me, I think we need more favourable numbers.

We must also consider:

- Uncertainty with equity investments
- Potential damage due to own behavioural choices
- Realized returns would also be lower because of taxes

However, please appreciate the impact of various assumptions. The threshold of 70% outperformance. The different returns threshold for the 2 decades. The assumption that post-tax cost of loan is same as pre-tax cost of loan.

We could have used 60% instead of 70%.

If your effective cost of loan (for the repaid amount) is lower due to tax-benefits, then you can consider the analysis accordingly. In that case, your return threshold can be 8% instead of 10%.

## Still, the Picture Is Not Complete

Why only Nifty? Why not Nifty Next 50 or Nifty Midcap index or Nifty Small cap index or any actively managed fund? Or a hybrid or a balanced advantage fund? Or why not a mix of moderately or negatively correlated assets (equity, gold etc)?

**Valid question.**

Picking up an actively managed fund for this analysis is complicated since that brings in another level of decision making. Hence, I am not inclined to use such funds for comparison.

For the other indices or investments, we shall try to compare in some of the upcoming posts.