There is something about leading a loan-free life that cannot be quantified just mathematically. Peace of mind is a desired side-effect of having no loans. Isn't it?
And it is for this reason that many people are very aggressive about trying to repay their home loans. At times, this aggression turns into obsession. And that is when it demands a second thought.
There should be a balance between trying to prepay your loans quickly and other aspects of your financial life.
Compromising on lifestyle
I recently came across a person who was literally living hand-to-mouth, trying to prepay as much of his home loan as possible. Whenever he had any surplus leftover from his monthly income, it would straightaway go towards prepayment of the loan. He would plough his annual bonus too back into the loan. It’s a personal choice, no doubt. But hear me out for a while.
But before we move forward, understand that there is no question about ‘not trying’ to repay your regular home loan EMIs. It’s a legal requirement and you just have to do it. The question here is whether you should pay over and above the regular EMIs to foreclose the loan; if yes, then how much should you stretch yourself?
People obsessed with prepayment of home loans, at times, ignore the fact that there are other goals for which money must be saved. Having an emergency fund is critical. Never make the mistake or using the emergency fund to prepay your home loan. You never know when a financial emergency will strike and, when it does, you would definitely want a financial buffer.
Saving for other goals
Next, Children’s higher education costs are skyrocketing and you know that. So, delaying to save for it just because you intend to ‘first clear the home loan and then do other things’ can backfire big time. You need to save for the goal simultaneously.
Retirement is another goal. Many ignore it in the initial phase of their careers, thinking that saving for retirement can wait for later and that prepaying the home loan must come first. That can be done. But retirement math works in such a way that the more you delay saving for it, the higher the amount you need to save when you begin. So, it’s an individual’s choice then.
Then there is another aspect to this discussion.
You know that home loan rates are pretty low these days. In fact, they are very close to historical lows. And if you add the tax benefits, the post-tax loan rates fall even further. So hypothetically, if you can invest surplus money elsewhere where you can get better returns than post-tax loan rates, then it doesn’t make mathematical sense to prepay the home loan at all. But this invest versus prepay discussion is not for everyone.
The right way to make prepayments
-The very first thing, and it’s a no-brainer, is to ensure that you continue to service your regular home loan EMIs. What else? You also need to continue paying for non-negotiables such as your family’s basic living expenses. Isn't it?
-Once this is done, don’t jump to begin prepayment. First, ensure that you have some money saved up for emergencies. They say it’s good to have six months’ expenses worth of emergency fund; but to each his own.
-After the emergency fund is ready and you have a surplus, start investing for important goals such as children’s education first. You might be tempted to prepay the home loan, but start saving for this goal first.
-Once that is done and assuming you still have surplus left, you can sit down to think about whether to prepay your home loan or not.
-If home loan’s quick closure is a priority, you can use this surplus to prepay every month. Or, you accumulate the surplus for some time and then prepay it once in a while.
-As mentioned earlier, there is another option. Instead of prepaying every month, you start investing the surplus in equity funds. Assuming returns are reasonable and you keep investing for several years, you will end up saving a large enough corpus. This corpus can then be used to close the loan in one shot when it becomes larger than the outstanding loan. There is another benefit of this approach. You will always have a sort of buffer with you, which can be used in times of need. Or, if home loan rates start rising, you can use the saved money to make prepayments.
So, take out some time and think about what’s the best approach for you. And if you are not sure, do not hesitate to take help from a capable investment advisor.