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.

Are you depending only on salary income to grow your wealth?

Thanks to our education system, we have adopted the attitude of studying instead of learning in our school and college days. The traditional school of thought ingrained in our minds right from our childhood days by our parents and teachers has been to earn good grades and pursue higher education so that you get a decent job for financial security. A majority of us,i.e., the working population depend upon salary income to fulfill our needs and aspirations.Our salary takes care of the daily householdexpenses,EMIs,insurancepremiums,contingency expenses,etc. The savings from salary are deployed into investments which in turn generate additional income from us.

For our other financial goals like a vacation, children education and marriage, we depend upon savings from salary.There is too much of reliance only on salary income for a major part of our lives to fulfill our needs and aspirations. In the case of working people, too often, the inadequacy of the salary vis-a-vis their aspirations or even their basic needs compel them to compromise on their standard of living. 

So besides the salary and investments that you make out of it, how do you grow your wealth? Unless you win a lottery or receive inheritance, how is it possible?

Besides this sudden exceptional money, there are opportunities galore. To tap these, all you need is sheer passion and a simple income enhancing idea. Some of these are:

• Favorite past times during weekends can be converted into a money making venture. And it need not essentially require a huge capital amount to be invested. For instance, conducting weekend workshops like dance, cookery,painting, yoga, stitching, photography (popular during summer vacations too) 
• Freelancing
• Blogging
• Teaching (Visiting Faculty)

 These ideas also apply to women who have taken a sabbatical from work to take care of their kids.

Then there are options like earning house rent which can be a good source of regular income.While this would require huge amount of capital initially, it requires the least amount of supervision and effort later on while pursuing a full time job.

Due to financial compulsions, most of us are caught in the work grind. Pursuing parallel part time opportunities which are of our interest and passion can be a truly liberating experience and a great stress buster. Besides, it can support income stream from our regular jobs and this could be utilised to fund say a part of annual vacation trips,EMIs, children's education fees,etc. So a bit of extra income always helps to boost wealth and eventually lead us to the path of financial freedom. And, the only thing you require to pursue a parallel stream of income is PASSION!

Letter from a Widow who is a Chartered Accountant

There are certain basic aspects of our financial life which we take too much for granted. For instance, location of our important documents, nomination status of our investments, bank accounts and insurance policies, will planning,etc.  But just one question makes these issues all the more significant: What if I am not there tomorrow for my loved ones?

Just take a minute over this question. Then further ask yourself the following questions:

· Have I kept all my important financial documents at one central location? If yes, have I communicated this to my family members?

· Have I bought life insurance to secure my family responsibilities that include household expenses, children’s future education expenses, outstanding loans,etc.

 · Do I remember about the nomination status of my old investments?

· Is my spouse just a nominee or a joint holder of my bank accounts and investments?

·  Have I prepared a will?

If the answer to most of the above questions is in the negative, then you need to work on these issues and ensure that in your absence, your family members do not have to go through the financial and legal hassles.

Financial planners usually take care of this basic issues of due-diligence  which are otherwise commonly ignored by the general public.  I am sharing with you all a letter from a widow who recently lost her husband in a road accident. It describes her struggle in coping with financial and legal matters in his aftermath and offers lessons which she has learnt the hard way. It aptly highlighs the importance of financial and estate planning.

Excerpts from the letter:

We always believe we will live forever. Bad things always happen to others.

Only when things hit us bang on your head you realise…Life is so unpredictable…

My husband was an IT guy…all techie…And I am a chartered accountant…Awesome combination you may think…

Techie guy so everything is on his laptop…his to do list…his e-bill and his bank statements in his email…He even maintained a folder which said IMPWDS…wherein he stored all login id and passwords for all his online accounts…And even his laptop had a password… Techie guy so all the passwords were alpha-numeric with a special character not an easy one to crack…Office policy said passwords needed to be changed every 30 days…So every time I accessed his laptop I would realise it’s a new password again…I would simply opt for asking him ‘What’s the latest password’ instead of taking the strain to memorise it.

You may think me being a Chartered Accountant would means everything is documented and filed properly…Alas many of my chartered accountant friends would agree that the precision we follow with our office documents and papers do not flow in to day to day home life…At office you have be epitome of Reliability/Competent/Diligent etc but…at home front there is always a tomorrow…

One fine morning my hubby expired in a bike accident on his way home from office…. He was just 33…His laptop with all his data crashed…everything on his hard disk wiped off…No folder of IMPWDS to refer back to…His mobile with all the numbers on it was smashed…But that was just the beginning…I realised I had lot to learn…

9 years married to one of the best human beings…with no kids…just the two of us to fall back on….but now I stood all alone and lost…

Being chartered accountant helped in more ways than one but it was not enough…I needed help…His saving bank accounts, his salary bank accounts had no nominee…On his insurance his mom was the nominee and it was almost 2 years back she had expired… but this was just a start…I didn’t know the password to his email account where all his e-bill came…I didn’t know which expenses he paid by standing instructions…

To read the full letter, click on the link below:

http://thingslearntaftermithun.blogspot.in/