Here are a few tips to decide whether to Prepay EMI or Start an SIP:
An equated monthly installment (EMI) is a fixed amount that the borrower pays to the lender. It is paid by the borrower at a specified date each calendar month.
Equated monthly installments are composed of both interest and principal amount. It is structured in a way such that each month the amount of interest and principal of the outstanding balance gets reduced proportionately over a specified period. Upon expiry of the loan tenure, the loan is paid off in full.
The first EMI consist of the maximum interest component and the lowest principal component. With every following EMI, the interest component goes down while the principal component keeps going up. Hence, the final EMI has the smallest interest component and the highest principal component.
The EMI is based on several factors like principal borrowed, the rate of interest, tenure of the loan and monthly/annual resting period.
For a loan having a fixed rate of interest, the EMI remains unchanged for the entire duration of the loan. However, it is subject to one condition; there shouldn’t have been any default or part-payment in between.
These days almost every consumption and investment asset can be purchased with the help of EMIs. Consumption asset includes durables and electronic items. Investment asset consists of residential and commercial property.
EMIs in case of real estate loans are spread over a considerably long period ranging from 20 years to 30 years. The borrower keeps paying fixed periodic amounts to the lender over the course of several periods with the aim of retiring the loan.
The main advantage of an EMI is that you know the cash outflow that is going to take place each month. You can organize your finances efficiently and according to those outflows.
A prepayment implies the settlement of a loan by the borrower before its official due date. The borrower may prepay either the entire outstanding balance of the loan or the amount of EMI for the upcoming date of the month for which the borrower is contractually obligated to pay.
Standalone, prepaying the outstanding balance of a loan looks favorable proposition. However, if you probe deeper, then whether prepayment option is good or bad depends on the circumstances.
The conditions influencing your decision to prepay a loan are as follows:
Type of loan
Whether you should prepay or not depends on a lot on the type of asset funded out of the loan. In other words, the purpose of loan determines its prepayment.
You might take a loan to fund a consumption asset or an investment asset. Consumption asset is like a refrigerator, consumer durables or electronic goods. These assets are depreciating in nature.
Depreciating nature of consumption asset implies that these won’t give impetus to wealth accumulation.
On the contrary, investment asset like house property or a site usually appreciates over the long term. As your home loan extinguishes, the market value of your house would have grown multiple times than it was at the time of purchase.
Financial prudence suggests financing depreciating assets with ready cash. However, if you have got an array of loans in your portfolio, it’s better to prepay loans taken on depreciating assets. You may decide to prepay loans on other investment assets afterward.
It has been observed that your credit score affects more adversely on default in payment of loan on depreciating asset as compared to defaulting on home loan EMIs.
Tenure of loan
The length of duration for which you take loan also influences your prepayment decision. Especially, in case of long-term loans like home loans, prepayment decisions can make or break your financial soundness.
Usually, banks use this trick to lure you into selecting a longer duration. There’s an inverse relationship between the tenure of loan and amount of EMI. The higher the duration of the loan, the lower is the amount of EMI that you need to pay.
Consider a case where you need to choose between a duration of 20years wherein the EMI is Rs 40000 vs. duration of 25years wherein the EMI is only Rs 30000. You are going to choose 25years owing to a lower EMI.
Also read:Pre emi vs EMI
This will be regarded as an irrational decision. On the face, the amount of EMI might look lower, but the secret of financial jeopardy lies within. You might end up paying double the interest on a 25year loan compared to interest outgo on 20year loan.
The prepayment decision can be derived out of this phenomenon. If you have taken a number of loans, then try to prepay the loan having the longest duration. In this way, you could save a lot of bucks on your debt servicing.
The amount of EMI
Loan component is best viewed as a last resort. It is a big drain on your earnings. You should ensure that it shouldn’t exceed 50% of your monthly income.
If you are holding a diverse loan portfolio, then it might be delaying your other goals. EMIs can lead to huge cash outflows. It’s good decision to prepay loans to reduce your debt burden.
In case you are servicing 3 to 4 loans of similar duration, then try to prepay one with the highest amount of EMI. You will be able to reduce your psychological and financial burden. Moreover, you will be able to regain confidence in your finances.
Start an SIP
It might happen that you have got financial goals to achieve and loans to shoulder. You want to payoff loan as well as invest simultaneously.
If you have a lucrative investment opportunity in hand, you may think of investing and debt-servicing simultaneously.
Consider a situation wherein you need to choose between Rs 30000 EMI of 20 year and Rs 25000 EMI of 25 years. Imagine that the interest rate on loan is 10% p.a.
Suppose you can earn 12% annualized return by investing in a diversified equity fund. In this case, you may use the saved EMI of Rs 5000 (Rs 30000-Rs 25000) to initiate an SIP in an equity fund.
In this way, you can leverage on the differential of 2% (12%-10%) to earn a higher rate of return; while servicing your liability. After some time, you will accumulate a corpus to prepay outstanding balance of your loan.
However, this strategy will work only till such time the rate differential is maintained. The differential advantage would decline with each basis point decline in the difference in the rate.
Consider yet another situation! You have taken a home loan of @ 10% for 20 years and are in the middle of your EMI schedule. Out of 240 EMIs (20*12), you have paid 120 EMIs, and 120EMIs (i.e., Rs 10 lakhs outstanding loan balance) are remaining; i.e., another 10 years are left for the loan to expire.
At this point, you make windfall gains and get an amount of Rs 10 lakh from another source of income. Now you are confused whether to prepay the loan or start an SIP.
You can start an SIP in a diversified equity fund provided if you are earning a higher rate of return say 12% on equity fund, getting a tax benefit and capital markets are rising. Prepaying the loan would be better if capital markets are falling because in that case, SIP won’t generate a higher rate of return than interest rate payable on the loan.