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.

Our focus - Incomes less Expenses

This magic equation never fails. This is the ultimate truth of our financial well being

Incomes less Expenses = Resultant Surplus.

At the end any surplus money that we have in hand is always the result of our incomes exceeding our expenses. Some may say that they do have money in hand but that comes from borrowing. This series of posts have not taken “borrowings” as a means of cash inflow. I have stuck to “conventional wisdom” or a “conservative approach” if you will.

These resultant surpluses do not automatically become savings. These have to be managed for them to become savings. A person or family having a surplus could

- Save and invest, or

- Spend the surplus away on consumption, or

- Use this for asset acquisition, or

- Prepay debts taken earlier for any purpose.

Each person / family would, presumably, choose any of the above options in their best interest and depending on their financial position. I am referring to option -2 above. It is not necessarily irrational to choose spending especially if surpluses have been adequately put aside and built-up in the past.

We eventually need to build our understanding on how to manage our surpluses. This is in essence the core of “Financial Literacy”.

A note on borrowings:

Easy borrowings to facilitate spending, fortunately has not been a part of the larger Indian psyche. It did make its presence felt mainly in urban areas and amongst youth but thankfully has been a restricted phenomenon. The growth rates in “loan products” has seen a phenomenal rise in the past decade or so but the absolute figures still seem in control.

Borrowings, however, have been accepted as a norm to finance asset acquisitions like buying a house or car or some other assets. The best part is such borrowings never run their full course. People tend to pre-pay their loans and be debt-free. A normal fifteen year home loan has an average life of just seven – eight years.

This shows the general aversion of an average Indian to carry debt in his name and a sense of shame attached to inability to repay or repossession of the asset acquired out of that debt.

I also think, the spectre of slowdown, job losses and loss of confidence in sustainability of one’s income flow has in the recent past slammed the brakes hard on free spending. One can sense a general tightening of belts and postponing non-essential expenditure.

Some interesting links for those interested in further reading:

1. http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4105
2. http://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=198
3. http://www.mydigitalfc.com/personal-finance/indian-consumers-turn-debt-averse-survey-595

We shall examine the basic principles of money management and how our surplus money may be handled.

The Second Aspect of our Financial Health Card

We have seen how Incomes and Capacity to earn are influenced by a host of many factors, including our upbringing, attitudes and the like.

In this post I will discuss about the outflow of money on account of expenses.

Whilst Incomes are largely steady and fixed for those employed and lumpy and at uncertain intervals for the non-employed category, expenses without exception are regular month on month with spikes large or small.

It is an eternal truth that money has a velocity and flows in a cycle continuously changing hands. The flow is inevitable, only the velocity keeps changing.

This flow of money in the economic system broadly represents income for the recipient and expense for the spender.

Incurring an expense is the act of spending money to get goods, services or satisfaction in return. Let us delve a little deeper in this. Expenses (including expenditure for the technical minded) can be divided as follows

Normal living expenses

These are the day-to-day expenses that are necessary for living in the current day and age. These would cover expenses on food, clothes, rents and taxes, electricity, conveyance, education, health, communication, information.

Such expenses are relatively inflexible and we have to incur them in order to live (more dramatically – survive). Even here where we presume relative inflexibility, we find that depending on income levels and propensity to spend, expense levels will vary across different strata of society.

Asset acquisition

It is always a dream to have one’s own house and in India, this is a great life time project. I will classify house buying as key asset acquisition expenditure.

Discretionary

These are expenses on goods and services which are not in the “Must Have” category. They can be classified as “Nice to Have”.

Let me try and give an illustration…….A foreign vacation is a discretionary expense to one while a visit to a movie at a multiplex could be a painful (and therefore discretionary expense) decision for another.

Simply put, these are expenses which may be postponed if you choose not to incur them. One has to think before committing to these expenses.

Emergency

These are normally associated with health problems, accidents, sudden unexpected events (travel on account of death of a near and dear one) and therefore unplanned and unforeseen.

If you observe closely, three of the above are not water tight silos and expenses are not rigidly classified under each.

Depending on the level of income and other factors many expenses will move from being Normal Living expenses, Asset Acquisitions and Discretionary. I presume that food and other survival expenses will never be classified as a discretionary expense. However, to a family which has “Chapatis” for breakfast, the decision to have corn flakes will become discretionary.

Similarly, buying a car may be a normal living expense to a professional/businessman earning say Rs.50.00 lakhs per year, asset acquisition to an executive earning Rs. 15.00 lakhs and discretionary to one earning Rs. 5.00 lakh per year.

In this post, I have explored the basic nature of “Expense” and attempted a broad classification. My next post will take this further and examine “Expense” further from a different perspective.

A Closer Look at Some Factors Influencing Our Financial Position

The previous post examined how Income was a result of choices made and how a person shaped up in life. It is amazing to see how our family background and our upbringing impact our attitudes and approach in later life and how this eventually links up with capacity to earn.

Let me share some of my observations here. These are not judgments or a discussion on what is right? Or what is wrong? This is an attempt to highlight some of the influencing factors.

Let me discuss one case (names, places and time not considered relevant for our discussion) in our neighbourhood that I had a ring side view for over two decades and made me ponder on what shapes financial position in later life.

This is an instance of two families with similar financial and educational background, working in very similar jobs with single earning members and staying in typical one bedroom (1BHK) apartments. A typical middle class family that one sees all over.

Children of both families attend the same school with reasonable above average intelligence. Nothing out of the ordinary here and logically the future should largely be parallel.

What happens is something like this….The child from one family goes to qualify as a brilliant doctor with top rankings and the younger child goes to be a brilliant industrial designer. Opportunities abound and monetary position is on a distinctly higher level.

In the second family, one child completes graduation and gets a job in a bank. whilst the younger becomes an engineer and gets a job in a medium sized engineering firm. Incomes are on a slightly lower level.

Let me clarify here – I am not getting into a discussion on luck, destiny or any such matter. This close observation of over two decades helped me trace many differences between these two families and I believe they have played a major role in shaping up attitudes of these children, their approach to problems, their enthusiasm, passion for anything in life, their tenacity …..infact their intellectual and emotional quotient was different.

Some of the factors have been - emphasis on education, family discipline, bonding, reading habits, outlook and attitude of parents, responses to difficult times, social networking, manners and social etiquette….etc.

I was amazed at why all these play a role in shaping our financial position, amongst others, in later life. I almost dismissed this as a one-of co-relation but then as I got deeper in the financial markets, I got an opportunity to interact with innumerable people and found that my earlier observations were not random. This kept coming back quite regularly till I was convinced that my observation were indeed not a flight of fancy.

This does not suggest in any way that we are powerless to better our lot. In fact, hard work, smart work, enthusiasm and passion are a must that need be inculcated in every child and it is our birth right to aspire for betterment in our lives and we have seen numerous instances when this has happened. Some of us will probably vouch that this has been their personal experience.

I urge readers of this post not to start an analysis of their own lives and imagine shortcomings where none existed in the first place. There is nothing right or wrong about this just as there is no agreement on How much money is enough?

In my next post, I will look at Expenses – the second aspect of the financial literacy puzzle.