Assess the risks, not just the benefits in continuing home loan at a lower rate

Few weeks back, I had covered an article on home loan titled ‘Prepay your home loan in small chunks and reduce your liability’.

Conventional wisdom states that one should pay off home loan as fast as possible and become debt-free. But I have come across a section of people who find it beneficial to continue their home loans! Such financial decision is guided by the following logic:

• If the investment rate is more than the rate of interest charged on the loan, i.e, if the return on investment is higher than the interest paid on home loan, then it is beneficial to continue the loan and invest the surplus amount in high yielding options.

• Under S/24 of the Income Tax Act, interest paid on home loan is allowed as deduction from total income up to a maximum limit of Rs.1.5 lakh per annum.

But are these benefits worth enough to live on debt for a roof which you can’t claim your own for a major part of your productive working life?

I am not going into the calculation part in this article but there are a few issues here which I would like to highlight.  

This strategy is unlikely to work for borrowers who take such financial decisions for a short term on an ad hoc basis depending upon the attractiveness of investment options in a particular year. It will not work for the simple reason that interest charged on home loan is compounded on a monthly basis, so the effective interest rate is higher.  On the other hand, most fixed income investment options like fixed deposit offer returns on a compounded annual basis and hence the difference compared to the interest rate would not be much. Rather than repaying the loan, investing the surplus funds in equities with a short term horizon is also risky. So a borrower is better off to repay the loan in the initial years as the interest component is huge.

Now, let us assume the case of a borrower who had taken a home loan at fixed rate of 8.5 per cent per annum few years ago. He adopts the strategy of delaying his loan prepayment and instead builds an investment corpus to pay off the liability at the near end of the tenure.

Even if the investment returns are high over a longer period of time than the interest paid, this approach may prove to be a risky proposition. The borrower needs to have a fundamental understanding of the following issues:

 1. Evaluating safety net: 

This involves assessing one’s security and well-being in the event of a worst case scenario like loss of job or death of the bread earner in the family saddled with debt. The borrower needs to address the following questions:

• What if I lose my job tomorrow? Will I have the capacity to repay home loan alongside my normal household expenses?
• If I am physically incapacitated, partially or completely by any accident, will I have the capacity to repay home loan?
• If I cannot repay my home loan in the event of job loss or some unfortunate incident which affect my capacity to earn regular income, do I have a second home to live in? Am I left with no alternate option but to sell the house? 
• What if I am not available for my loved ones tomorrow? Have I bought insurance cover to cover for the repayment of loan liability? If not, how will my loved ones manage to repay the loan.

2. Understanding the difference between asset and liability:  

While doing a cost-benefit analysis of the investment returns vis-à-vis home loan interest payment, some people also take into account the appreciation in property prices. They perceive that if the property being bought on loan has appreciated more than exponentially compared to the interest paid during the tenure, there is no harm in continuing the loan at a lower rate and pay interest on it.

Most people do not understand a fundamental fact which is that the capital gains on property is notional unless it is bought as an investment asset and planned to be liquidated eventually. On the other hand, interest paid on home loan is for real and goes out of the personal pocket every month.

The house that is self-occupied can never be an asset, it is a security for a roof over the borrower’s head. When it comes to personal finance matters, an asset should be perceived as an item which generates additional income. On the other hand, the house is a liability and will remain with the bank as mortgage unless and until the entire loan is paid with interest. 

Conclusion: Giving priority to repayment of the home loan does not mean one compromises on other financial goals. Usually, an individual typically takes a home loan near his 30s. After servicing the EMI, he also needs to save for his next logical goal which is children’s education. As a borrower’s income increases, he can repay his loan in small chunks and along side divert a small sum to investments.

The general human tendency when faced with many choices is to opt for a solution which gives the maximum benefit. But one also needs to analyse what kind of risks, if any, are being undertaken to achieve that benefit. It is prudent to take calculated risks in life, particularly in financial matters. At the end of the day, we are all yearning for financial security which can give us peace. No one wants to spend sleepless nights worrying about some mountain of debt. So it is advisable to review one’s financial situation in totality because a financial decision can never be sound until it offers mental peace.