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POSTED BY ON January 3, 2011 6:25 pm COMMENTS (6)
I have recently received 3 lakhs through a sale of old family property. I have 2 loans running, following are the details:
1.) Car Loan – Principal Outstanding: 3,47,000/-, 24 installments complete, 36 left, EMI: Rs. 12000, Rate of Interest:12%
2.) Personal Loan – Principal Outstanding: 1,38,000/-, 107 installments left, EMI :2190, Rate of Interest 13.75%
I wanted to figure out if its a better idea to partly pre-pay either of the loans or rather invest the money in Mutual funds which can yield better returns. Considering that the larger portion of the interest has already been paid.
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That is my opinion.
the reasons are:
1. In an equal EMI plan, that too so skewed one like a home insurance EMI, with so long a payment schedule. for a time frame of 15-20 years, the initial years are relatively very burdensome because you tend to borrow maximum money on the current pay package and for the initial 5 years or so, the major amount of EMI is just to pay the interest and not the principal.
2. After say 5 years, there is distinct change. The EMI remains the same all these years but now most likely your pay has increased quite substantially and now the EMI starts paying the principal in a more significant manner.
3. After 10-15 years, the EMI pays a large amount of money as principal and in the last few years, the EMI is largely the principal only.
4. Over time, the inflation decreases the purchasing power of money and also the effect of EMI. So more pay plus inflation actually decreases the effect of EMI exponentially.
If you prepay anytime after 5 years, you are just paying the principal. You have already paid the interest. So why to give the loan institution the benefit of interest as well as the principal back.
Loan per se is not bad if the earnings generated by the asset (home is an asset, both emotional as well as monetary) because of that loan is more than the interest you are paying. All big institutions do it, all banks do it (borrow from RBI and you @3.5-6% and lend it to you @ 8-12-16%), etc etc.
Hope this explains the point.
Ramesh
“For an asset forming loan like home-loan, I will say no need to prepay anytime!!”
Can you please elaborate?
Is there a rule of thumb to arrive on this decision?
I have seen experts giving different answers on this. Hence, my curiosity.
Thanks Ramesh, you sealed the deal for me!
Thanks Ramesh,
I am salaried so I guess what you say makes sense. But you think 12/13.75 % is tough to get in a 3 year window, even in aggressive equity funds?
Then would you suggest that I start investing an equal amount of the EMI (after prepayment) in SIPs?
Sunit
Yes, it is tough to get. Because for small period of time, unless you are very proficient in picking up stocks and you are lucky, you would not be able to make that amount of money.
What-if markets tumble down 40% in the next year. Your strategy will be down and out. You would not be able to have the courage to remain for 3 years consistently!
But if you prepay those “expensive and non-asset forming” loans, then you will be mentally free!!. No gastric ulcers then even if markets tank!
For an asset forming loan like home-loan, I will say no need to prepay anytime!!
Thats my view.
Ramesh
It depends upon whether you are taxed as a salaried person (then you should pay off your loans) or you are a professional / business guy (then mostly you should use the interest payoffs as deductions and accordingly not prepay).
Since both these loans are “non-asset forming” loans, it will be better if you pre-pay them and then use the rest of the money to build assets.
If you are thinking that you will be able to get better returns than 12/13.75% consistently, that is a difficult thing to do in a short term.
Hope this helps.
Ramesh