Imagine a hypothetical scenario. Your employer offers you a loan at 2% p.a. You can choose any loan tenure you want. 5 years, 10 years, 20 years. You can take such a loan only once. Even if you were to leave the employer, you don’t have to close the loan. You can continue to repay the loan gradually by way of EMIs.
At the same time, your bank offers bank fixed deposits at 6% p.a., irrespective of FD duration. It is a flexible FD where you can withdraw and reinvest whenever you want. I know FDs don’t work that way but let’s play along.
What Would You Do?
How much will you borrow? What will you choose as the loan tenure?
Any rational investor and borrower would say, “Borrow as much as you can and for as long as possible”.
Why? Because this is risk-free money (arbitrage) for you. You can borrow at 2% p.a., invest the same money at 6% p.a. and net a cool 4% p.a. without any risk.
On an employer loan of Rs 50 lacs, you can easily make 4% * 50 lacs = Rs 2 lacs per annum. I understand the loan amount will go down gradually and hence your risk-free income will also go down, but this gives a very fair idea.
Why Would You NOT Borrow for a Short-Term?
If you take a Rs 50 lac loan at 2% p.a. for 5 years, your EMI will be Rs 87,638. Total EMI payout over the loan tenure = Rs 87,638 X 60 = Rs 52.58 lacs. Total interest payout = Rs 2.58 lacs.
If you take the same Rs 50 lac loan at 2% p.a. for 20 years, your EMI will be Rs 25,294. Total EMI payout over the loan tenure = Rs 25,294 X 240 = Rs 60.7 lacs. Total interest payout = Rs 10.7 lacs.
Since you pay a lower interest in the 5-year loan, you should opt for a loan tenure of 5 years. And not 20 years.
This suggestion does not sound very wise, right? Yes. That’s right but why?
Because I have not considered the full information. The information that you could earn of risk-free return of 4% p.a. on this borrowed money by putting all this money in a bank FD. Armed with this information, unless you have deep rooted disdain for any kind of debt, you will most likely go with a longer loan duration.
Therefore, you cannot just base your loan tenure decisions on the nominal interest payout over the loan tenure. Do note, by opting for a shorter tenure, you do not change the interest cost (or interest rate of your loan). It remains the same. 2% remains 2%. 8% remains 8%. You just change the nominal interest payout. And appreciating this aspect is important.
Further, it is not that your money sits idle.
For instance, the 5-year loan had EMI of Rs 87,638 and the 20-year loan had an EMI of Rs 25,294. If you have opted for a longer tenure, I would expect you to invest the difference (Rs 62,344) somewhere. And that investment will earn you some return.
If the return is better than the cost of the loan, you are clearly better off with a longer tenure. In the example I considered, that was indeed the case. Borrow at 2%, invest at 6%. However, that’s not how things work in real life. For you to earn better returns than the cost of loan, you will have to take some risk, and risk does not always pay off. Still, the question to ask is: What will you do with this difference?
Note: If you think you will splurge the difference (and not invest), then you are better off with a shorter tenure.
Yes, you may feel comfortable with the burden of debt removed from your shoulders. Certain categories of loans such as a home loan involve an emotional angle too. You want to own the house completely as soon as possible and that won’t happen until you repay the home loan. I understand those points, but you must consider other aspects of your finances too.
A shorter tenure means a bigger EMI. Can you afford such an EMI?
Going by the flawed logic on making tenure decision based on nominal interest payout, I have seen borrowers go with shorter loan tenures and then struggle to run the house budget. This can compromise your quality of life and the ability to invest for other financial goals.
You may think that you can make up for the lower investments after the loan is over. Yes, you can do that, but wealth creation does not require just big investments, it also requires time to compound. An unnecessarily big EMI commitment may take away that time from you.
It is always better to opt for a loan tenure that is comfortable. Such that your quality of life is not affected too much and you can continue to invest for your long-term goals. Moreover, since most loan products are now also available with floating interest rate and the RBI does not permit banks to charge any prepayment/foreclosure penalty on floating rate loans, you still retain the flexibility to close the loan sooner. You may have opted for a 20-year home loan, but that does not prevent you from closing the loan in 10 years. You can always prepay when you have excess funds and reduce the loan tenure.
As a borrower, figure out ways to reduce the interest rate on your loan or rather get the loan at as low rate as possible. This will indeed make a difference. Don’t be needlessly fascinated with the quantum of interest payout while deciding the loan tenure. Opt for a comfortable EMI.