Loan pre-payments: Look before you leap :: Business Line

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With inflation showing little signs of loosening its vice-like grip, the RBI raised its key policy rates again last week — the tenth rate such hike since March 2010. Borrowers are in for a double whammy. Along with a rapidly increasing cost-of-living bill, they may have to shell out more to service their borrowings too. With most loans these days being of the floating variety, banks and financial institutions are likely to pass on their increased cost of funds to borrowers, who have to brace themselves for higher outgoes or extended repayment periods, or both.

With an increased strain on the pocket, does it make sense for borrowers with surplus funds at their disposal to pre-pay loans? The psychological comfort of owning an asset free of debt, especially a big-ticket one such as a home, is undoubtedly high.

Doing away with the Damocles sword of the lender over one's head seems to have intuitive appeal. Particularly, when the interest meter on the loan is ticking away fast and furious. That said, it may not be prudent to rush into the decision without doing some simple math. Here are a few points to consider in the pre-close-versus-continue decision.

Can you deploy it better?

More often than not, interest rates on loans and those on deposits tend to move in tandem. What this means is while lenders begin squeezing out more from you on the loan, you too can possibly earn a little extra on your surplus funds. Check whether you can deploy your funds more profitably than by using them to close the loan. If the potential return from investing the funds is higher than the cost of the loan, it may not make sense to pre-pay. While making this comparison, it is advisable to consider returns from relatively safe investment options, such as bank deposits, PPF or bonds. And, importantly, make the assessment of both potential return on investment and cost of loan, on an after-tax basis.

Say, for instance, on a pre-tax basis, you could earn 10 per cent on a fixed deposit, while the rate of interest on your loan is 11 per cent. In such a case, the choice to pre-pay would seemobvious. But enter taxes, and the picture may change. Tax breaks available on some categories of borrowings, such as home loans, reduce the effective cost of the loan. Principal repayments on home loans are covered under Section 80C, which allows a maximum deduction of Rs 1,00,000, while interest payments are allowed as deduction up to Rs 1,50,000 on self-occupied houses and to the full extent on other houses.

For a person in the highest tax slab (30.9 per cent), who borrows a home loan at 11 per cent, the effective cost of the loan works out to around 7.6 per cent. The cost of the loan is reduced by around 3.4 per cent (30.9/100 * 11 per cent), thanks to the tax breaks. The higher the tax slab, the lower the after-tax cost of the loan. On the other hand, investment income may be subject to taxes too, which eats into returns. In the above instance, for a person in the highest tax slab, the after-tax return on the fixed deposit with a rate of 10 per cent is 6.9 per cent. In this case too, since the after-tax effective cost of the loan is higher than the after-tax effective return of the deposit, it may make sense to prepay the loan. However, if you consider an investment in PPF, which gives an 8 per cent tax-free return and is also covered under Section 80C (to the extent of Rs 70,000), then pre-paying the loan may not be such a good idea anymore.

In this case, you may be better off investing the surplus. The bottom-line is, make your decision to pre-close or not, based on the opportunity cost of the funds on an after-tax basis.

Pre-payment penalty

Another key factor to watch out for is the pre-closure penalty being charged. Several banks charge a penalty, which could vary between 1 per cent and 3 per cent of the amount being pre-paid, for settling a loan before its due date. This acts as a disincentive against pre-payment. Some banks currently do not charge a pre-closure penalty, if payment is made from the borrowers' own funds. However, if pre-payment is made by refinancing the loan with other banks, this waiver is not given.

The good news is that the RBI has repeatedly frowned upon pre-payment charges levied by banks, and the results are beginning to show. SBI, for instance, has waived off prepayment penalties on its loans. If other banks also take the cue, it will be a welcome step for borrowers, with one negative variable taken off from the pre-pay-or-not decision matrix.

Till such time this happens, don't hesitate to bargain with your banker regarding waiver of the pre-payment penalty. With interest rates rising, bankers would probably be willing to waive off these charges.

After all, they too would be on the lookout for funds to re-deploy at a higher rate. Another way to get around the pre-payment roadblock is through part-prepayment. Many banks do not charge pre-payment penalty for amounts settled up to a specified extent, say 25 per cent of the loan outstanding. A borrower may consider pre-paying the loan to such extent, and continue servicing the balance.

For borrowers intending to part pre-pay, it makes sense to do so in the initial stages of the loan. Under equated instalment loan repayment structures such as EMI, the interest component of the loan is much higher in the initial instalments than in the later ones. Since part pre-payment is adjusted directly against the principal outstanding on the loan, payment in the initial stages results in a significant reduction in the future interest outgo. A part payment at the later stages would be less beneficial, since the bulk of the interest would have been paid by then.

Target the big pocket-pinchers

This one is a no-brainer: If you have multiple loans, those which carry the highest rate of interest should be paid off first. Not all debts rank equal. Some are undeniably more detrimental to the borrower's financial health than others.

On top of this list are outstandings on credit cards, which carry exorbitant rates of interest and are a sure-fire way of falling into a debt trap. Before pre-paying relatively benign forms of debt such as home loans, make sure to settle higher-cost debt such as credit card outstandings and personal loans.

Emergency Funds

In your urge to liquidate debt, don't go overboard in cleaning out your bank account. Remember to keep a sufficient cash reserve (say, living expenses for six months), which will come in handy in case of emergencies such as layoffs and unexpected medical expenditure. There is little point in pre-paying a relatively low-cost home loan, only to go in for a costlier personal loan within a short period