Turn your loans into Investments

Did you know that the loan tenure & total repayment amount - payable over this tenure (inclusive of interest & principal) - moves up exponentially with just 1% rise in interest rate? In the following example (Table 1), you will notice that just by increasing interest rate from 11% p.a. to 12% p.a., the tenure increases from 20 years to approx 29 years AND the total repayment amount increases from Rs. 4.9 Million to Rs. 7.2 Million! This is of course assuming that the interest rate will not change in future & that you keep the same EMI as before. This is true for those who have existing floating intt loans. The EMI for such loans has already been decided. Hence any movement in rate of intt directly impacts the tenure.

From Table 1, it should be clear that an intt rate increase of 1% in absolute terms causes both the tenure & total repayment amount go up by more than 45% each! One may ask if this is equally true for fall in rate of intt too. The answer is – No. If the interest rate falls from 11% to 10%, then in the same example, the tenure & total repayment will both come down by approx 17.5%! If you are one of those who have a question of why this happens, then send me an email & I will explain. It should suffice to mention here that the pace at which one repays principal largely defines tenure & total repayment amount.

4 year back (June 2004) the home loan intt rates were 7%. Those have been rising steadily up-to 13% today for many banks!

One usual discussion point that I come across on lunch tables these days is – ‘What are the options in current economic trend that can help us beat the superfast pace of inflation?’ While I agree that there are not too many options that can reliably make this happen, I wanted to start discussing about a few that are promising. As mentioned in one of my last posts, it is absolutely important for an average investor to play defensive in economic conditions such as today. As part of the current series of posts, I have already presented the option of Gold. In this post, I am going to discuss the ways in which we can make our existing borrowings work for us.

Most of the types of consumer loans today have intt rates higher than the rate of inflation. Consider one of the most popular & cheaper forms of consumer loans – home loan. Even this presumably cheap form costs more than the inflation today.

My recommendation is to use part of your investable funds to repay at least some part of your loans – if the rate of interest is more than inflation i.e. if the intt rate > 11.7% p.a. (as of today) & if your objective is to beat inflation.

One would argue – what if I invested in some other option than repaying my loan? One of the most reliable long term options (accessible to average individuals) is Bank FD with a reputed nationalized bank. The rate of intt on these is not more than 9% today. Table 2 shows the comparative gains for 2 options. Continuing the same example as Table 1, let’s assume that the rate of intt has gone up to 12% & that you have Rs. 100,000 to invest.

It is clear that repaying the loan is financially wise option, even if we assume that in Option 2, the bank offers monthly compounding option (as assumed in Table 2) on the Fixed / Long Term Deposit! If we assume half yearly compounding (which is realistic), then the gain with option 2 becomes even less glamorous! Again with Option 2, you are not beating the inflation too!

If the option existed for average individuals, then the best thing to do is to borrow in Yens in the International Monetary market & re-pay or invest in India! Yen denominated loans are the cheapest (not more than 0.75% p.a.). One could have used these Yens to repay the Rupee loans. One catch is that one would have to assume the currency fluctuation risks until the Yen loan is squared off. However I think the quantum & surety of gains is worth the calculated risk. But alas! This option is not available (not at least in the direct forms) for people like you & me.

Anyways, back to our original discussion. Lump sum re-payment makes more logical sense when you are expecting that the intt rate on the loan is either going to remain at present level or will go up. It is not ruled out that the present intt rates on various home loans will revolve around current levels for at least few years to come. You can of course actively look at the option of increasing EMI to maintain the same tenure as before. A mix of lump sum repayment & increase in EMI can also be considered.

In general, whether for beating the inflation or not, it is one of the prudent financial policy (for an average investor) to continue re-paying the loans that carry highest intt rates on a regular basis. I have one strong belief – “Becoming risk-free is the solid step in being a high risk-taker.”