Why this kolaveri to pre-pay home loans?!

It is very common to see discussions on rent a house vs buy a house  and pre-pay a home loan vs invest instead. Sooner or later, someone participating would utter the word 'emotional' (or some variant of it). The rent vs buy choice is largely governed by emotions. The pre-pay vs invest choice is largely governed by emotions. Right! Enough said.

This post is not about why home loans need not be pre-paid. Otherwise, I will have to face long lectures on why living in debt is very wrong.

This post is to ask, why are those emotions not being extended to retirement? Why is nobody (save a few) emotional about retirement planning as they are about buying a house or pre-paying a home loan? Is it a case of  "I only worry about what I can perceive today"?

Let us now explore case by case the logic behind each of these emotional decisions.

Rent vs Buy

This is something I can fully understand. I know several of my relatives who lived in small rented houses and moved every couple of months. It was a torrid experience for them. It is quite natural to want a place that we can call our own. There is no argument here.

However, excuse me for asking a couple of questions:

  1. Why the kolaveri to buy asap? Why buy in places you are not likely to settle in? Can the decision to buy not be postponed for a couple of years until the cash flow situation stabilises?
  2. Why buy a house that you cannot afford? Why buy with 80% of the cost on loan? Why not 60%? Why buy with an EMI that is close to 50% of gross pay?

While I can understand the burning desire to buy (hey I dream too), why not add a pinch of logic? Why not look at money holistically and include life goals into the equation too?

Is buying a house more important that our financial well-being in retirement? Why not take some emotions off from buying and add it to retirement and see how it plays out?

Please don't say that the house can be reverse mortgaged at retirement. No one does that. They want to 'leave it to the children' regardless of whether they want it or not.

Pre-pay vs Invest

The situation here depends a great deal on the situation above.  If those questions had  been asked, if the purchase had been delayed a bit, if the EMI was not too large then the fear of living in debt would not be so much.

Unfortunately many people jump from the frying pan of wanting a house to the fire of living in debt. Why do people pre-pay asap? Why are they advised get out of debt as soon as possible?

Because

  1. It is debt and it is 'bad'. Enough said.
  2. of pressure from parents. Why? Because debt is bad.
  3. the EMI is too high and stifling.
  4. they are worried about losing their job
  5. they are worried about fluctuating interest rates

Like I said, this post is not about why home loans need not be pre-paid. In fact, I would like to suggest just the opposite. Go ahead and pre-pay asap but do consider this route of prepayment:

Let the EMI continue. The moment you get some extra cash, either from salary or via bonuses or other forms of income put it an overdraft account if your loan account offers one. You retail full liquidity of the amount deposited while the loan gets closed out sooner (or EMI decreases for the same tenure). For the same tenure,  the loan interest saved becomes part of the available balances and earns interest = home loan rate. Thanks to Ajay for pointing this out.

If you do not have an overdraft facility, put the money in an arbitrage fund or if you can be a bit more adventurous in an equity savings fund or even more adventurous in funds like Edelweiss Absolute return fund or ICICI Balanced advantage fund.

The amount is meant for prepaying the home loan, but you don't actually do it. As long as you are earning, the EMI is paid from your salary. While the pre-paying corpus grows. It is insurance.

If there is a layoff, the EMI comes from the insurance. If there is an interest rate spike, the excess comes from the insurance. Each time you put some money into this corpus, the debt noose around your neck loosens bit by bit.

You continue to derive tax benefits with growing debt insurance. You can pre-pay anytime you want. If you can ignore the urge to pre-pay and let the loan run its course, you will be left with a decent corpus for your other goals. Win-win.

Now, wait just a minute. why can't I focus on pre-payment and then focus on investing? You sure can, but it is a question of time. It most often is.

People often spend many years in pre-paying and do not invest enough. This can severely impact the corpus that they can accumulate for other goals. Here is an illustration: Calculator: Prepay Home Loan or Invest?

There is no free lunch. Very few can service a large EMI, prepay it soon and then invest enough for financial goals. Becuase very few earn that much or have the potential for significant income increase in future.

By building a corpus as pre-payment insurance, you continue to remain emotional about pre-payment but also become emotional about retirement or any other financial goal.

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7 thoughts on “Why this kolaveri to pre-pay home loans?!

  1. Ajay Sharma

    Hi Pattu Sir,

    In regards to your statement: "Let the EMI continue. The moment you get some extra cash, either from salary or via bonuses or other forms of income put it an overdraft account if your loan account offers one. The amount will grow tax-free at the loan rate."

    --> Do we earn interest on the surplus amount in an OD account at the loan rate? You mean, if my loan rate is 9.5%, any surplus amount in my OD account will earn me tax-free 9.5% interest?

    Please clarify.

    Reply
    1. freefincal

      Sorry about this. I will have to rewrite this. As you keep paying into the overdraft acct, the interest outgo decreases. The interest part is calculated on the principal outstanding minus the amount deposited. The EMI will then come down. The actual amount deposited will not earn any interest but is fully liquid. Or the EMI can be kept constant and the home loan will be completed sooner.

      Reply
      1. Nikhil

        At least with SBI MaxGain, the EMI doesn't change on surplus deposit. You save the corresponding interest amount but the principle deduction is as per the amortization schedule.

        Reply
  2. Mukul Jaggi

    Where is the unlike button

    (considering the advice provided against prepayment - totally ignoring the power of compounding & justifying the grass is greener on the other side scenario)

    Reply
  3. Mukul Jaggi

    Where is the unlike button

    (considering the advice provided against prepayment - totally ignoring the power of compounding & justifying the grass is greener on the other side scenario)

    Probably the author should read - "The little book of Behavioral Investing" once again 🙂

    Reply
  4. Shan

    Sorry pattu I have to strongly disagree with this post. do you advise someone to take a loan against property to 'invest' in some arbitrage fund? No. But that's exactly what you're saying here .

    Reply

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