Last Updated on October 1, 2023 at 4:31 pm
A reader says, “I have an ongoing home loan. The EMI is about 25% of my take-home pay. I cannot be at peace because of this home loan and wish to pre-pay the loan as soon as possible. Am I right?”
It turns out that that reader had sold all existing stocks and mutual fund holdings to fund the property partly – a possible reason why the loan outgo to take-home pay is a comfortable 25%.
Now the reader wishes to pre-pay the loan for peace of mind aggressively. Of course, there are multiple solutions to most problems, and if this is the way the reader wishes, there is nothing wrong with it.
However, let us try and view the problem in a different light. The reader is quite emotional about being in debt and wants to get rid of it asap. Fair enough, but what about financial independence in retirement? Should we not be emotional about that as well?
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Every month that we delay investing the right amount for retirement is a month lost forever. For every year delayed, the investment amount would increase at a rate far higher than inflation (12-14%). See, for example: Here is why you need to start planning for retirement asap!
Why do we fail to be emotional about this? Is this because we cannot “see” the problem? Why do want to opt for extreme solutions? Why can’t we find a balance between servicing debt and investing for long term goals?
In the present case, the 25% EMI to take-home ratio is a good number (even if it has come at the cost of extinguishing a sizeable net worth). So we recommend investing as much as possible from the remaining income and prepaying the loan in small chunks each time there is a bonus or salary increase.
Many people assume that the interest component paid to banks is a “waste of money” and want to get rid of the debt asap. This line of thinking is logically flawed. The interest component is the cost of borrowing and is why we own the property in the first place.
More importantly, the time component is spread over several years. During this time, inflation would reduce its value while our salaries and net worth would increase (if we invest correctly). Thus the burden begins to ease with time. Of course, only those who stay calm and service the debt will appreciate this benefit. If we rush and pre-pay the loan, the bank is the winner. We have advanced their expected cash flow over more than a decade to just a few years.
That said, I agree that debt is not a good state to be in. So can we find a balance? We can if set our minds to it.
- Invest as much as possible for long-term goals with the right asset allocation.
- Out of this investment, assume that a small portion is for home-loan pre-payment.
- You can even track this chunk separately if you wish.
- You can redeem this chunk and pre-pay anytime, but don’t do it. Let it grow undisturbed.
- You can now sleep relatively better because you are now readying funds for prepayment. Even if you lose your job or have a break in income, this fund will act as a buffer.
- Think of it as building a resource to prepay your income at any point, just that you will strive to build this resource as much as possible without actually using it for prepaying, giving in to an (irrational) fear.
- The more you do this, the more you get used to this arrangement, and the more this resource will grow.
- Use any extra income, such as bonuses or increments, to pre-pay the loan in small chunks while you do this.
- Let the home run its course or at least 60-70% of its course. The remaining amount in the resource is part of your net worth.
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