Sunday, March 1, 2009

To Pre-pay or not…….Make your choice

I have been writing posts which shall eventually lead to a broader discussion on financial literacy and the approach to take to manage one’s finances.


In my last post, I had reasoned that everything boils down to a simple equation (Incomes less Expenses = Resultant surplus). One of the uses that this surplus can be put to is the pre-payment of past loans taken.


I thought it might help if there is further discussion on this, exploring different perspectives.


There are two divergent approaches towards personal debt. Thereafter, there are many factors which influence our decision when to pre-pay an outstanding loan.


Classical economics:


This theory believes that we should never pre-pay loans.


India is in a growth phase (never mind a temporary blip) and a necessary by-product of this is inflation. With continuous inflation over a period (assumed to moderate and high in phases), the value of the rupee will keep falling over the life of a loan. You therefore end up paying back the loan with a cheaper rupee. The value of the rupee continuously erodes over this period due to inflation.


Let us look what inflation has done to the rupee in the last five years. At an average inflation of 6.5% in the last five years, the value of a rupee has fallen 27%. Rs. 100/- (in 2004) is now worth Rs. 73 only. Conversely, due to inflation, you would need Rs. 138/- to buy what cost us only Rs, 100/- in 2004. As the rupee becomes cheaper due to inflation, the burden of repaying debt will progressively reduce.


Traditional economics:


This theory belongs to that school of thought which believes that loans are an unnecessary burden and if we have surplus cash which has no immediate use, then you must utilize it to prepay outstanding loans and reduce your indebtedness.


The rationale is to be debt free and not to live on borrowed money.


Let me now discuss some of the factors that we take into account whilst taking a decision to prepay a loan.


Income Tax incentives.


Our Income Tax rules allow us to pay lower tax if we have a housing loan outstanding. The amount of interest that we pay on our loan can be reduced from our total income for calculation of our tax liability. This results in our income tax being lower.


For every Rs. 100/- paid as interest, we save income tax of Rs. 33.99. The net interest that we actually end up paying is Rs. 66.01. Logically this should be an incentive not to pre-pay the loan.


Surplus cash flows


The borrower may, a few years down the road, have surplus cash flows. This may happen due to increase in income levels, large receipts as bonus, incentives, large business deals / orders, lucrative assignments or gifts / legacy receipts.


The idea is if alternative investment options do not give return more the interest we pay (as in the current scenario), it makes ample sense to pre-pay the loan out of the surplus that we have. If the surplus is not significant, it makes sense to continue with the loan. Remember the old maxim (modified slightly) – A penny in liability reduced is a penny earned.


This will result in reduction in liability and increase in money-at-hand.


The second factor seems to contradict the rationale of utilizing tax incentives. There is some point at which tax incentives stop being material. If you look at that point closely, you have to spend Rs. 100/- to get a tax incentive of Rs.33.99. The day we start asking the question – Why don’t I pay Rs.33.99 and have surplus cash of Rs. 66.01 in hand, we must start prepaying our loans.


From the above arguments, there is no standard solution applicable to every borrower. Each situation is unique and has to be dealt with accordingly. Other factors like, levels of income, flow and sustainability of incomes, impact of commitments in terms of expenses apply and the decision could be not to prepay.


If you were to turn around and ask me what would I do? – I would probably prepay a fifteen year loan within seven – eight years and free my cash flows. Free cash flow also gives me flexibility and the ability to grab good opportunities that may present themselves from time to time. I must also confess that I am a bit of a traditionalist at heart.

13 comments:

Vinod_Sharma said...

Mavin, that was a very informative post from someone who knows the game and the theory behind it too. The value of the rupee will keep falling and therefore "the burden of repaying will progressively reduce". How succinctly put.

Since you have spoken of housing loans and the tax breaks you get on them, it does not seem to make great sense to pre-pay such loans, unless you really want that additional cash in hand for whatever reason, and the reasons can be many.

A friend of mine had taken loan in the eighties. Over a period of time the EMI became an increasingly small part his monthly income. Besides, rental income grew in the opposite direction. So, he pre-paid a small balance when he took a second and bigger loan for another property for which started claiming a bigger tax break. And also more rental income that offset the EMI.

This is the sort of solution he is suggesting to others too. He is dead against making any pre-payment, no matter what the interest rate. What is your view on this?

Indian Home Maker said...

Hi Mavin, thanks for this informative post :)

As the value of rupee goes down and incomes increase the EMIs do become less significant, not to mention the rise in property prices .. so would you say prepaying the loan is kind of unnecessary?

Gopinath's "Artickles" said...

Yes, Mavin, there are ample reasons in favor of not prepaying a loan. In fact I wonder with credit rating agencies what would appeal a borrower who pays as per schedule or one who pays in advance?

Mavin said...

Vinod - IHM - Gopi

If you were to look at this only on economic considerations, it does not make sense to prepay loans. Vinod - Your friend is right.

However, a sweeping statement like this is subject to other factors. If large incomes accrue and the expected returns on debt in the market are at around 11% - 12%, one can utilise the surplus as a pre-payment. Housing loans now cost around 11%.

Currently, my take is further reduction in housing prices. In some places it could just crash.

This will in turn depress rentals. So if you were to lock-in housing loans at low costs, rentals could be subject to downward pressures.

Gopi, it may make sense to prepay if it would improve your "Borrower Rating" entitling you to lower rates. It is not so yet in India.

manju said...

Mavin, very informative post explaining the pros and cons of pre-paying a loan.

If the value of the Re. always goes down in our economy, I wonder why some people opt for floating loans. Would it not make more sense for everyone to take out loans at fixed rates?

Indyeah said...

Thank you for this really informative post Sir:)
Being someone who knows practically nothing about economics these posts are proving to be really amazing for me.

L. Venkata Subramaniam said...

But arent loans structured in such a way that the benefits to the customer only start in the later years. What I mean is that in a 15 year loan, the first 5-6 years you are just replaying the interest. If soon after this phase you repay you are actually losing?

Mavin said...

Manju,

The lender will opt for floating rate of interest as it will seek to protect itself from fluctuations in the market. I do not think the borrower has much choice here.

Any housing loan has a typical life of fifteen years. Repayment of principal stretches over this period. The rupee will get cheaper over this period due to inflation.
Incomes will normally keep up with inflation whilst the EMIs remain constant.

There is no link between the interest modalities with the rupee getting cheaper.

Mavin said...

Thanks Abhi. Hope these posts are helpful.

LVS,

You are right. Equated Monthly Installments (EMI)method will upfront payment of interest for the first five - seven years.

Subsequently principal payments start becoming a major portion of the EMI.

It makes sense to pay interest in the first five years or so and claim tax breaks. As interest payments taper, one may consider pre-paying the principal amount provided the borrower has surplus cash and is not getting adequate returns.

As mentioned in my post - on strict economic considerations, pre-paying does not make sense. Plus you have the advantage of paying back the principal with a cheaper rupee.

Solilo said...

This would be a different take when you live in USA. You know the credit based structure of USA is totally different from that of India.

This made an informative read.

Mavin said...

Solilo,

Thanks.

I guess so. I must admit that I am completely ignorant about systems there.

Yes I do believe that many people are perpetually in debt and just keep rotating it from one card to another.

In India things seem different.

Anrosh said...

however credit cards and loans are a saving grace.

just because you do not have money, it doesn't mean you cannot go to school - but can take a loan.

credit cards are a great thing for people who knows to take the benefit of the system - create temporary cash flow.
And haggle for a low interest credit for a good credit history.

The cons for the credit card holder is what keeps the credit card company in business.

mavin, do you teach ? you will make a great financial columnist

Mavin said...

Hello Anrosh,

Credit cards are a convenience and not a means to live our lives.

Over reliance on credit cards in an environment encouraging people to spend, gets people in deep debt. They spend the rest of their lives trying to juggle to the best of their ability.

No, I do not teach yet but many have suggested that I do. Maybe soon.

Thanks for the compliment. Maybe I could try my hand at that too.