Payoff Mortgage or Invest….continued
Let us take a real life case and see what is to be done when you have a lump-sum amount. Should you repay the loan amount or should you Invest that money?
The sad part is YOU need to take a decision TODAY and you will be judged (you may be the judge) after 5, 10 or 20 years!
Facts:
Housing Loan amount: Rs. 36L
EMI 36000 * 20 years (2012 to 2032)
Already paid for 1 year…but the loan amount would obviously not have gone down much…..
Now this person has Rs. 4 L lumpsum. If he were to pay off the lender (Hdfc) what would happen?
It will result in Reduced Installments from 225 installments to 165. i.e 60 * 36000 (2027 to 2032 waived off) – this means about Rs. 19,60,000 of the total amount to be repaid will go down.
Or he could have bought 550 shares of Hdfc Ltd. or 550 shares of Reliance Industries. Or he could have Invested Rs. 400,000 in say Franklin India Blue Chip. Or Hdfc Prudence. Or Icici Prudential Discovery Fund.
What could have been the result? Difficult to say.
Let us say in 5 years the scenario was as follows:
Hdfc was worth Rs. 8L, Reliance was Rs. 6.4 lakhs, – mutual funds were about Rs. 7 Lakhs each.
Let us assume that ON that date when he offers Rs. 8L to Hdfc, they are willing to drop 72*36000 installments – 6 years installments saved instead of just 5 years.
Actually what has happened is he has saved interest of 10.65% – i.e. he is making an assumption that equity markets (or real estate) will give him a return LESS than 10.65% p.a. for the next 20 years on a CAGR BASIS – or he is NOT capable of earning 10.65%p.a. and hence he is repaying the loan.
People should be calculating their net-worth on a regular basis and seeing whether their NET WORTH is increasing. However the big bad loan figure sits there scaring them, so they want to see the amount reduce / disappear asap.
Now let us see why I would be happy with such a situation:
As a shareholder of Hdfc I should be happy…because the borrower has already paid processing fee for a 20 year loan. The customer has perhaps paid for a 20 year TERM INSURANCE (premium included in the loan amount), …the real beneficiary is Hdfc.
What would have I done? No clue. But the chances are I would have bought 4 shares of Rs. 1L each. Maybe auto ancillaries? Just found scrips with 7% dividend yields. Not bad I should say.
pattu
If retirement is far away, then only investing (for retirement) makes sense. Many with a home loan cannot or will not be able to invest enough for retirement. They better read up on the anti-home loan (reverse mortgage) and pray that they qualify for one.
IsItPossible
What happens if stock market tanks!!! how much return are you getting and loan is NOT going anywhere….
subra
pattu the problem is too many experts will not understand the impact of a. reversion to mean b. standard deviation and c. long term asset class behavior – as well as the ACTUAL impact vs PERCEIVED impact. So what you are saying is correct, but wait for the other comments – and you will know why ‘Man’ is NOT a rational animal. Maths be damned, emotions be the king!
George
Hi Subra
Could you tell me regarding the auto ancillary companies that is posting near 7% dividend yields
Thanks
George
subra
Rane Madras, …
Bhaskar
Few points to ponder upon:
1)In absolute reality loan term reduced/paid early is a huge emotional benefit surpassed by all asset classes 🙂
2) We never know how equity will perform but early payment means my debt is surely going down
3)Processing fee is a sunk money so lets leave it sunk 🙂
4)I am not making HDFC any richer if I prepay my loan rather I am making a big contribution to my lifestyle by decreasing stress and knowing I have some control
So in my opinion its better to prepay home loan within some limits
What do u say Subra sir…
babon
Hi Subra Sir,
How does it work out if he has capacity to pay higher installment amount every month? i.e. lets say instead of having a lump sum of 4L, he can repay 4L in say about 5 years. Which option is better in case – repay loan or invest in SIP mode in MF?
Rajesh
Hello Subra,
if we get 4 as lumpsum, then 2 as investment, and other 2 for Home Loan prepayment.. Kindly share ur opinion?
Thanks
Rajesh
sixtyniner
I fail to understand that on one side everyone cribs about inflation on a daily basis everytime they go to buy veggies……but on the contrary, fail to understand the importance of leverage, fail to understand that even with 6% inflation, the same 36 lacs loan will be reduced to less than 18 lacs in 7-8 years from a purchaing power standpoint and the inflation applies to the cost of money as well….net net….there is no business case for prepayment, its just fear and insecurity that plays on everyone’s mind…..invest invest invest, direct eq, div mf, bal mf, mid/small / sectoral / index whatever makes sense to you over prepayment to HDFC…..and last but not the least…those can do it…they do it, those who can’t they preach…those who can’t preach….they teach…those who can’t even teach….they pray.
Sachin
Subra sir,
I don’t understand mathematics, but I will use lump-sum amount to top-up my investment for entirely different reason.
Reason – This 36,000 EMI keeps me straight and prevents me from spending the money on many unnecessary things. (like buying that Rs 10 lakh car you mentioned some time back)
If I reduce the EMI, I may not be disciplined enough to invest the surplus money monthly. I just may end up buying that 10 lakh car on EMI.
If I reduce the number of EMIs, some saving is going to occur 5-10 years down the line which is difficult to understand now.
If I invest this lump-sum, it will raise my mental and financial comfort and reduce my stress. I will stick to my 5 year old santro.
BTW – I never had this problem. I don’t know anybody who has this problem. Me thinks it is a hypothetical problem only.
I wish I had this problem!!
subra
i have done a lot of posts on repay vs invest. You should always take a 16 year view – if you have a 16 year loan. So a 3 year or a 5 year answer makes no sense. Over a 16 year period equities should give a better return than 10.65. Suddenly if you see a 82% return on your equity, you should feel happy that YOU had money in equity…at that time of a bull run removing say 10L from a Rs. 100L portfolio WILL make sense….generally if the market has not done anything good for say 4 years – there is no point in repaying. Also if your ctc is Rs. 36L and you have a Rs. 4L surplus – like the guy in my portfolio – makes NO sense to repay. My view.
Vandhana
Great post…it is often the emotional thought of ‘let me be debt free’ that causes one to repay a loan without considering other options..This post helps to bring back rational thought and long term thinking into the decision making process.
Pravin
i dont think the safety now approach of getting debt free is wrong or correct.every person has his own time preferences.some people prefer the safety of now than the apparent return of the future.some people ,especially those whose cash flows are a little more stable, like to leverage this and benefit from investing.
just looking at interest rates wont help.not that anyone can predict it anyway.
Karthik
The general assumption is 10.5%/10.75% Interest cannot be beaten by equity. Even 6% FD(after 30% tax) can beat it easily. 50L loan with 10.5% for 15 yrs will have total interest expense 49.5 lakhs. 50L investment with 6%FD(after tax) will have total interest accrued 72L.
So 6% is enough to beat a 10.5% loan in 15 years.
Amortized reducing cannot beat Principal Compounding. 🙂
Jagan
Karthik
Had a doubt, then I should take a personal loan at 11-12% and invest on a product e.g. PPF at 8.25% and able to earn money without doing anything.. what is the catch — I should just have enough to pay the principle part is it for the early months???
Mohana Ganesh
Very informative. Have to really see the calculator working.
Dr Saneej Kanhirat
subra,
you rock.
I had the similar, exactly very similar experience. 40L home loan. for 20 yrs from hdfc. got 4L. what I did was repaying the loan. As it gave me more mental relief. But the mathematical logic you explained in this blog is really worth thinking.
Shankar Vasudevan
Lets assume Kumar has an oustanding balance of 35.5 Lakhs home loan. Let’s say he inherits his father’s property and can repay this home loan in full. (assuming no prepayment charges). Let’s calculate net cash in hand after 105 months (his loan would have completed in this time @ 53000 monthly EMI, home loan rate of interest – 11%)
Scenario-1:
Kumar closes home loan:
This gives him now a monthly surplus of 53,000 which was paid as EMI. Now Kumar decides to invest this in RD @ 8% interest for 105 months. Total amount in hand after 105 months is Rs. 80,55,110/-
Scenario-2:
Kumar invests 35.5 lakhs in FD @ 8% for 105 months and continues to pay 53,000 EMI to repay the home loan. His total expense after 105 months by way of interest paid to bank would be 19,71,000. Maturity amount in FD after 105 months would be 70,99,608. He also would have saved Income tax (max of 1.5 lacs @ 33.3% for 8 yearts = 3,99,600). So net cash in hand after 105 months after interest paid to bank would be Rs. 55,28,208/- (including the income tax saved).
Conclusion: simple RD gives more returns than the FD example given earlier in this page. Gives you piece of mind. To be same as RD yield one should assume 12% interest on FD.