Home loan EMI puts a lot of strain on my cash flows. I have hardly anything left to invest after these EMIs. I will start investing once I repay my home loan. This is very common refrain among individuals and families when I ask them about their financial goals and investments. Effectively, every other investment takes a backseat while you have a home loan outstanding. What do you make of such an approach to investments? In my opinion, you are inviting trouble.
In this post, I will discuss the problems with such an approach and how to get out of this mindset.
What is the problem with this approach?
You wouldn’t want to sell your house after you retire to generate income. You wouldn’t want to sell the house to finance your children’s education or marriage. This means you need other assets to finance these goals. However, you have maintained that you will start investing in other assets (equity, debt etc) once you finish repaying the loan.
Home loans are long term loans with tenor up to 20-30 years. So, if you take a home loan when you are 30, the repayment will end when you turn 50 or 55. You will retire when you turn 60. When will you invest for other life milestones?
Your house will give you shelter but you still need to eat, drink and travel. You still need to pay for hospital bills and doctor’s consultation. You still need to pay for your children’s education.
It is not that you spend everything that is left after repaying the EMI. You do save but don’t invest proactively. You invest in fixed and recurring deposits. During the tax-saving season, you will purchase a good-for-nothing life insurance plan which provides investment benefits too. Everything is on ad-hoc basis. There is no plan or discipline.
And when it comes to investments, nothing is more important than discipline.
With this approach, you can only HOPE to achieve your financial goals.
Personal Finance is quite simple. You need to purchase a house to stay in. Purchase adequate health and life cover. Have an emergency corpus. Get you asset allocation right. Set your financial goals Invest in equity heavy portfolio for long term goals. Invest in debt for short term goals. If you still got money after this, enjoy your life and do whatever you please to.
So, you cannot focus solely on home loan repayment. There are other aspects too that need to be taken care of.
If you find yourself in the same boat or want to avoid being in the same boat, here is what you should do:
Don’t purchase a house you cannot afford
This is the root cause. You purchase a house on a bank loan. The loan EMI eats up 40-45% of your take home salary. You borrow from friends and family to make the down payment. They need to be repaid soon. When you borrow too much, your focus is entirely to bring down your liability. In such a case, your other investments get compromised.
Borrow only as much as you can repay comfortably. And this is not just about home loan. It applies to all kinds of debt. Don’t borrow more than you can afford.
Slow and steady wins the race. Never underestimate the power of compounding
I do not have much left after EMI and monthly expenses. A small investment won’t make much of a difference. I will invest when I have a larger sum to invest.
You can’t be further from the truth.
“Compound interest is the eighth wonder of the world. He, who understands it, earns it. He who doesn’t pays it”. This was purportedly said by no less than Albert Einstein.
Let’s see what that means.
You are 30 years old. After taking care of EMI and other monthly expenses, you have just Rs 2,000 left to invest. If you invest Rs 2,000 per month till the age of retirement and earn 12% p.a., you will end up with Rs 69.9 lacs by the time you retire. Not a small sum by any means.
Time and Return both matter
The sooner you start, the less you will have to invest per month to reach a particular corpus. In this case, you need to invest Rs 2,861 per month to reach a corpus of Rs 1 crore in 30 years. If you delay your investment by 5 years, you can still reach that corpus of Rs 1 crore but you will have to invest almost double the month.
So, for a mere 5 years of delay, you have to double your investment per month.
That why it is extremely important not to delay investments and start investing early.
Additionally, you need to pick up the right products. If you invest in low return products, you will have money to invest more. So, even though you follow investment discipline but earn a return of only 6% p.a., you need to almost four times the sum to reach the same corpus of Rs 1 crore.
This is where you must avoid low return products such as traditional life insurance plans.
Start early and the choose investment products prudently.
Equity investments are too risky. I am content with guaranteed returns even if the returns are low.
In my opinion, settling for too low returns is a far greater risk.
You must get your asset allocation right. Having 100% equity portfolio is as stupid as having portfolio with no equity exposure.
Do not have flavor of the month approach to investments. Have a good mix of equity, debt, gold and real estate in your portfolio.
Have Financial Goals
If you have crisp financial goals in mind such as children’s education in mind, you will cut corners and find money for investment. It will also be easier to stick to investment discipline.
Remember you need smart goals. Compare how the two persons set their goals.
Investor A: Save some money for daughter’s education in 10-15 years.
Investor B: I need Rs 1 crore in 15-20 years (random large number, no reason why he needs Rs 1 crore)
Investor C: Need Rs 60 lacs for daughter’s education after 12 years
If you think like A and B do, you will find excuses, delay investments and even liquidate earmarked investments for other goals. This is because you don’t know what the target is. When there is cash flow pressure, you will reset your target and make it comfortable.
However, if you think like investor C does, you will make sure that you invest regularly, check the progress and maintain investment discipline. Target is quite crisp: Rs 60 lacs in 12 years. You have little option but to stick to investment discipline.
Spend what is left after investing
Once you commit to home loan EMI, you spend what is left after paying the EMI. I would advise you to add one more EMI to your cash flows. That EMI is your Investment EMI.
That investment EMI can be equity MF SIP, recurring deposits or even gold ETFs. The choice of instrument will depend on your financial goals.
At the moment, you cash flow position is like this:
Income – Home Loan EMI – Monthly Expenses = Investments
You need to change it to:
Income – Home Loan EMI – Investment EMI = Monthly Expenses
Spend what is left after investing.
Must Read: How SIP makes long term investing easier?
During the last year, Franklin Templeton came out with a series of ads where they SIP a good EMI. I couldn’t agree more.
At first, it might look like a naive approach but that’s not the case. If you carefully analyze your monthly expenses, your expenses can be classified under two broad categories viz. Discretionary and non-discretionary. Expense such as children’s school fees, medical bills, loan EMIs etc cannot be compromised and are non-discretionary.
Then, there are discretionary expenses such as dinner outings, frequent shopping and purchase latest gadgets, which can be easily cut down to some extent. You can reduce such expenses and increase your investments. If you reduce your monthly dinner outings from four to two, it shouldn’t have much impact on your lifestyle.
Even if it does, it is choice that you need to make. Enjoy now and make compromises later or delay gratification and enjoy later.
Should I invest or prepay?
You have excess funds with you. You are in a dilemma. Whether you should use the funds to invest or prepay existing loans.
Basic principle of invest or prepay is that if you can find an investment that offers you better returns than the cost of your loan, then invest or else prepay. So, if the cost of debt is 12%, invest if you can find an instrument that yields greater than 12% and prepay the loan if you can’t.
An additional point to consider is that the returns on investments are not guaranteed while you cannot default on your loan commitment.
Personal loans and credit card debt are quite expensive and must be repaid at top priority. These loans are available at 14-30% p.a. It is difficult to find an instrument that offers such high returns.
Home loans are different. A home loan is probably the cheapest debt available to retail customers. It is typically long term and offers tax benefits on repayment. Hence, the effective cost of debt is much lower. After considering tax benefits, the cost of a home loan will come down to 8-10% p.a.
Must Read: Tax Benefits on Home Loan Repayment
Though returns on equity mutual funds are not guaranteed, I believe the returns from equity should be able to beat 8-10% over the long term.
A number of investors want to aggressively repay their home loans. They want to repay the loan at the earliest so that they can become true owners of the house. It gives a lot of emotional comfort and financial security to the family. I can’t argue against this. However, sometimes this approach can compromise other investments.
In my opinion, if you can repay your home loan in a couple of years, then you can first prepay the loan and then think about other goals. However, if you know that even with accelerated payments, it would take you 5-10 years to repay the loan, do not delay other investments. Start investing for other goals right away.
You can still be aggressive towards repayment. Use monthly income for both investment and home loan repayment. Use annual bonuses for home loan prepayment.
If you are worried about how your family will repay the loan if you were not around, purchase adequate term life cover and educate your family about how to use it.
There is no size fits all approach to investing and financial planning. Do not go by what others are doing.
Set smart goals and work towards achieving them.
Do not get obsessed with repayment of your home loan. Repayment of housing loan is important but do not let it compromise your other goals. There are other life milestones too that you need to plan for.
Don’t wait till you can invest large sums. Start small. Let the power of compounding unleash itself.
Successful investing requires a lot of discipline. Your are extremely disciplined when it comes to home loan EMI. You maintain the discipline for 15-20 years. The discipline is forced. Bank will auction your house if you don’t meet the commitment. You need the same kind of discipline with your other investments too. And smart goals can bring that discipline. With time, this will become a habit.
Just like you can’t delay your home loan EMIs, you shouldn’t postpone other investments. Commit to an investment EMI. Earmark a sum to invest every month. And do not budge from the commitment.