RECENTLY, I met a very savvy businesswoman who had just received a windfall and she was in a tearing hurry to prepay her loan taken at a very attractive rate of interest. Her income is extremely high and EMIs were comfortable and technically there was no rush to prepay the loan. However, there was an emotional urge to pay off the loan. When I inquired further, I realised that she might require some funds in the next 18 months. I told her that she had already paid a lot of interest in the first two years and considering her financial need, she should really think whether it makes sense to prepay the loan.
She didn't have a clear answer to it. I went on to demonstrate how her loan repayment is scheduled.
The interest paid per year is 5.36 lakh. That means at flat rate of interest it works out to be 5.36%. This is excluding the tax benefits that she would have received on the interest payments. In her case, the entire interest can be claimed as expense. This translates into a savings of 53.63 lakh * 0.309 (tax rate) = 16.57 lakh. Hence, the actual interest payout post tax benefits will be 53.63 lakh – 16.57 lakh = 37.06 lakh. This means that 3.7 lakh will be the interest paid per year on a 1-crore loan and hence, the interest rate paid per year works out to be 3.7%. If she is able to pay more than 3.7% on this loan she should retain the loan.
Now, if one invests 1 crore for a period of 10 years, the number will speak for itself. 1 crore invested for 10 years at a compounded rate of even 6% will be 1.79 crore, which is 26 lakh more than the total payouts she would have made (without factoring any tax benefits). On a 8% return, the corpus jumps to 2.15 crore, which is 62 lakh more than the loan payout, whereas on a 10% return the corpus will be 2.5 crore, which is 1 crore more than the loan payout.
There were two key mistakes the lady had committed and I have seen many learned people making the same mistake.
Case 1:
Looking at this loan in isolation without understanding it's impact on overall financial requirements.
The lady made a very basic calculation and decided to pay it off. However, she forgot to take stock of her fund requirements in the coming months. She wanted to buy a piece of equipment for which she would have to borrow at 13%. A loan with an interest rate of 9.25% is a very attractive rate of interest, considering that rates of interest have gone up in recent times. For most people who have home loans, keep this in mind that a home loan is the cheapest form of loan and if you have secured it at a low rate of interest it does not make any sense to pay it off especially if you have any liquidity needs in the near future.
Case 2:
Not understanding the compounded returns needed to justify the loan.
Most people do not calculate the compounded returns required to justify a loan. They also forget to add the tax benefits that a business or home loan can provide and sometimes do not accurately calculate the returns they need to earn to keep the loan. As seen in the example above, even a compounded return of 6% justifies keeping the loan of 9.25%.
