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.
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.
