Got funds to prepay loans, where to start?

Karthik got promoted recently and received a hefty annual bonus. He has been struggling with his cash flows recently and decides to use the bonus wisely. He has an outstanding home loan, a car loan, a personal loan and an education loan. A significant portion of his monthly income goes towards EMI payments for these loans. Due to his recent struggles with cash monthly flows, he has also run up a sizeable credit card debt. He plans to prepay some of the debt to ease the pressure on the cash flows. A smart approach indeed. It would have been better if he had avoided taking up so much debt in the first place. Well, you can’t change what has already happened. You can only rectify your mistakes or reduce their impact.

But, there is a problem. He does not know which loan to prepay first. He thinks part pre-paying the home loan is the best approach since it has the largest EMI. A home loan will typically have the longest tenure too.  Is Karthik right in thinking this way? Let’s find out.

Interest Rates and Loan tenures

A home loan can have a tenor up to 30 years and interest rates vary from 9.7% to 12% p.a.  Interest rate for car loans varies between 10%-13% with a tenor of up to 7 years. Interest rate for personal loan varies between 14-18% with a tenor of up to 5 years. Student loans/education loans are typically priced between 10% and 18% p.a.

Credit card debt is the most expensive debt and the cost may be as high as 3-3.5% per month. Thus, annual interest cost may go as high as 42-50% p.a.

These are tentative interest rates and the exact interest rate offered will depend upon multiple parameters including but not limited to base rates, repayment ability, employment status, security etc.

Parameters to consider when planning to prepay loans

1. Interest rate of the loans: You must repay the most expensive debt first. If you have two loans at 10% and 12% respectively, prepay the loan with the higher interest rate first.

2. Tax consideration: Principal repayment or interest payment for some of the loans may face a much favourable tax regime than the others. For example, principal repayment and interest payment for a home loan carries tax benefits under Sec 80C (up to Rs 1.5 lacs) and Sec 24 (up to 2 lacs for a self occupied house) respectively of the Income Tax Act. For a property that has been let out, entire interest paid can be adjusted against rental income. Interest payment on an education loan is deductible from your income under Section 80E.

With these tax benefits, the effective interest cost of the loan comes down.  For instance, for a Rs 50 lacs home loan (10% p.a., 20 years), the post tax cost comes to 7.2% p.a (for a person in the highest tax slab). This is the cost you must use for comparison. Hence, rather than looking at absolute loan interest rate, look at effective interest rate (after considering associated tax benefits).

3. Pre-payment penalty: There will be no prepayment penalty for floating rate loans. However, for fixed rate loans, banks/credit institutions may charge prepayment penalty. Pre-payment charged depends on the terms and conditions of your loan sanction. It is typically a percentage of your prepayment amount.

A high penalty can wipe out the cost savings from prepaying the loan. It is quite possible that a high interest rate loan has very high prepayment penalty too. With a very high prepayment penalty, it may so happen that you are better off prepaying a less expensive loan. So, you must consider this aspect while making the decision.

4. Depreciating asset: In case of extreme financial stress, you may have to liquidate the asset for which you had taken the loan. Wouldn’t you want that the market value of your asset should at least be enough to settle the loan? For instance, if the market value of your car is Rs 4 lacs and outstanding loan is Rs 3 lacs, you can sell the car and close the car loan.

With this thought, it may make sense to settle off those loans for those assets which depreciate faster. For instance, value of a car will depreciate much faster than a house. In fact with an education loan, there is no tangible asset created through loan. Or you may have taken a personal loan to fund your vacation.

5. Secured or Unsecured loans: With unsecured loans such as personal loans and credit card debt, the bank/financial institutions cannot lay claim on the assets created through such loans. Hence, in case the most unfortunate were to happen, the bank will not have any legal recourse to your assets.

This does not mean that you can wilfully default or do not care to make timely payments for these loans.  In case you default on the loan (for reason other than demise), your credit history/credit score will suffer and you will face problems in getting loans in the future.

A point to note: Since unsecured loans, by definition, are not backed by any security, these are likely to be the most expensive loans. It is no surprise that credit card debt and personal loans carry much higher interest rate than home loan or a car loan. If you go with this approach, you will make repayment of the credit card and personal loan debt your last priority.

Which parameter to focus on?

You can easily see some of the parameters do not go in tandem. If you go by interest rates, credit card debt should be settled first. If you go by depreciating asset criterion, an education loan or a personal loan should be settled off first. Alternatively, if you choose secured/unsecured criterion, prepayment of credit card and personal loan should be your lowest priority.

As far as depreciating asset criterion is concerned, there is not much concern. With the exception of student/education loan, the loans for assets that depreciate faster or the loans that do not create any asset are likely to be quite expensive.

The decision between secured and unsecured loans does not really matter. You need to make timely payments on both the loans when you are alive. So, default is not an option available to you. To square off your debt liabilities in case of untimely demise, purchase adequate life cover.

You do not want to default on your loan payments. So, don’t complicate matters unduly. Close those loans first that ease the pressure on your cash flows the most. You will do so by squaring off the most expensive loan first. While doing so, do consider tax benefits and applicable pre-payment penalty to arrive at the effective cost of loan/loan closure.

Make the decision a purely mathematical one.

Parameters you can avoid focussing on

1. Repay the loan with the largest EMI: For most of us, home loan will be the biggest loan and makes bulk of your monthly EMI expense. For a number of us, this will be the reason to prepay the home loan first. However, this makes little sense. Let’s consider an example. You have a home loan outstanding for Rs 30 lacs (10% p.a., 5 years, EMI: Rs 63,741) and a personal loan of Rs 5 lacs (14% p.a., 5 years, EMI: Rs 11,634). Total EMI comes to Rs 75,735.

You have Rs 5 lacs earmarked for prepayment. If you part-prepay the home loan, your home loan EMI will go down to Rs 53,117 and total EMI burden will go down to Rs 64,751. Had you used the amount to prepay the personal loan, your total EMI would have been down to Rs 63,741. Tax benefits associated with home loans and any applicable prepayment penalty have not been considered.

2. Repay the loan with the longest tenor: With this approach, you will most likely end up pre-paying the home loan first. Doesn’t seem right, does it? Continuing with the above example, if the home loan tenure was 10 years (and not 5 years), by prepaying the loan, you would make savings of Rs 7.92 lacs while you would make savings of Rs 6.98 lacs if you prepay the personal loan. You might be compelled to prepay home loan just by looking at these numbers.

However, please note savings of Rs 7.92 lacs is over a period of 10 years while savings of Rs 6.98 lacs is over a period of 5 years. Under such cases, you can think of prepayment amount as an investment and cost savings as returns. A simple internal rate of return (IRR) analysis will show you that prepayment of personal loan is a better investment (14% vs 10% of home loan). IRR is same as rate of interest on the loan (if you do not consider other factors)

Alternatively, applying a discount factor of 8%, present value of total savings (in home loan pre-payment) equals  ~ Rs 5.74 lacs. PV of total savings (in personal loan prepayment) equals ~Rs 6.02 lacs. Using a discount factor of 8% is not the right approach but it gives you an idea.

3. Keep your emotions out: A lot of us want to get the close the home loan as early as possible. No surprise, everybody wants to shut out bank’s claim on your house. By prepaying the home loan, you would also ensure that your family gets the house easily in case of your demise. As discussed before, make the decision purely mathematical. To take care of your liabilities in case of demise, purchase adequate life cover.

Illustration

Let’s try to assess total savings in case of prepayment in different kinds of loans. We will take up home loan, car loan, personal loan and education loan and find out prepayment of which loan offers you the best savings.  To make the comparison easier, then tenure of all the loans has been taken as 5 years. Tax benefits and prepayment penalty have also been considered during the analysis.

You can see, without considering tax benefits and pre-payment penalty, you would have prepaid student loan before car loan. However, the order reverses after accounting for tax benefits and pre-payment penalty.

Credit card debt has not been considered since it is typically not repaid in form of EMIs. However, given the high rate of interest charged on credit card debt, credit card debt is the one you should close first before thinking about prepaying other loans.

Prepay loan or Invest?

A number of people ask whether they should use the bulk funds to prepay debt or invest the funds to generate good returns. I fail to understand why even the most conservative of investors become so creative when they have bulk funds in their hands.

For such doubts, there is a simple rule. If you can find an investment that offers better (and GUARANTEED) post tax returns than the cost (tax adjusted) of your most expensive loan, you must invest. Otherwise, you must use the funds to prepay the debt. Notice the emphasis on Guaranteed. This is because with risky investments, returns won’t be guaranteed. On the other hand, you must make your EMI payments.

Well, it is not easy to find such investments. So, keep it simple. Prepay the debt.

Alternative Approach

Although we have not discussed the approach in this post, you can calculate internal rate of return of cost savings by making the prepayment i.e. given the outgo of prepayment amount, calculate post tax savings with adjustment for prepayment or other processing charges. Use this to calculate IRR. Higher IRR means you have utilized your funds better.

Therefore, prepay the loan with the highest IRR. The result will be same as with the approach used in this post.

PersonalFinancePlan Take

Pre-payment of debt can result in significant cost savings over the long term. If you have taken up multiple loans, assess effective cost (post-tax) of various loans. Do consider the impact of prepayment penalty against interest savings before making the final decision. When it comes to financial decisions, it does not help trying to be too creative. Keep things simple.

Image Credit: Simon Cunningham, 2013. Original Image and information about usage rights can be downloaded from Flickr/LendingMemo

Deepesh is a SEBI Registered Investment Adviser and Founder, PersonalFinancePlan.in