Sandriano made a comment the other day with a question as to whether it’s better to invest in the NHAI bonds at 8.2% or pay off housing loan at 9%.
My response was that it’s probably better to pay off the housing loan if all your EMIs consist of mainly interest right now, but if that was not the case then we’ll have to look at it in more detail. He is in a stage where bulk of the EMI still consists of interest, and here’s how his loan looks like right now.
Thanks always for your inputs; always helpful in making informed decisions.
I think I got my answer. Nevertheless, here are the details. Bulk of the EMI goes towards interest.
Loan Amount: 28 Lakhs (LIC Hsg Fin)
Tenure: 20 yrs
Commencement: Dec 09
Interest: Locked for 8.9% for 3 yrs (until Nov 12) and market rate thereupon
Current Interest: 8.9%
EMIs paid till date (in months): 24
We will need to use the EMI calculator to see what the payment terms for this loan currently is and how will different payment terms affect this.
This calculator shows that the monthly installment is Rs. 25,000 – and during the term of this loan you pay Rs. 32 lakhs in interest in addition to the original 28 lakhs repayment. So, the whole repayment totals Rs. 60 lakhs over the period of 20 years.
This obviously sounds like a lot at first blush but consider the fact that Rs. 28 lakhs invested at 8.9% for 20 years compounded once a year yield Rs. 1.54 crores!
Now, Sandriano has already paid 24 installments so he has 18 years left, and theÂ NHAI bond had a 8.3% / 15 year option so let me just assume that you will be able to get 8.3% for three more years so we can have a straight comparison.
I downloaded this excel calculator for easy reference and found that on these terms – you would have paid about Rs. 6 lakhs in EMIs for the first two years, but the principal component of that would only be Rs. 1,11,084 and your outstanding principal is still Rs. 26,88,916 (out of the original Rs. 28 lakhs).
So, in a manner of speaking – it’s as if you’re going to take a loan for 18 years at 8.9% today for Rs. 26,88,916 and you suddenly get a windfall of Rs. 1 lakh and you want to see whether it makes more sense to pay off 1 lakh from the principal of this housing loan or would it make more sense to invest this in a tax free bond at 8.3% for 18 years.
If you pay off 1 lakh from the housing loan then your new principal is Rs. 25,88,916 and your new EMI is Rs. 24,082. So, your total cash outflow for 18 years is Â Rs.52,01,712 (24,082 x 12 x 18)
If you hadn’t paid off this house loan then your total cash outflow would have been Rs. 54,02,808 (25013 x 12 x 18). So, by paying off Rs. 1 lakh from the house loan, you save yourself Rs. 201,096 in lower EMIs over the course of this loan.
Now, in this case – you invested Rs. 1 lakh in the tax free bonds which earned you an interest of Rs. 1,49,400 (1,00,000 x 8.3% x 18 years) and you got the 1 lakh principal back at the end of the 18 years – so the total money you made in this investment was Rs. 2,49,400, which is Rs. 48,304 more than what you would have saved had you paid off your loan in the beginning of the time period.
So, based on this simple calculation I would say I was wrong earlier as you do get a higher cash-flow Â if you invest in the tax free issue instead of paying off the loan.
The one thing I would like to add is that in this comparison is that in case of investing the money – you get a very large chunk – Rs. 1 lakh at the end of 18 years, and even if you assume an inflation rate of 6% for 18 years – that one lakh will only be worth approximately Rs. 35,000.
In contrast – the EMI savings are constant throughout the time period and by virtue of not being lumpy their value might be more in terms of present value despite the absolute number being low.
I know that you can add many more variables to this calculation like tax saved, present value of future cash flows, reinvestment of interest etc. but based on my earlier post in which I compared the tax free bonds to a SBI fixed deposit – I feel that adding so many variables right at the beginning overwhelms many people without having any commensurate benefit.
Finally, given this situation what would you do and what are the other factors that you consider while deciding whether you should pay off debt or make an investment?