I have always advocated financial freedom, the ability to do anything you wish to do in life without worrying about money as the most important goal for all investors. This freedom cannot be achieved when one is straddled with debt, especially debt taken for buying personal assets, a house being one of them. I would like to share a few real-life stories and experiences that may help the reader make the right decision about loan repayments. These involve no Excel calculations but focus on the psychology of repayments.
Why do people hold back from repaying a housing loan?
Tax Benefits: Under section 24B of the Income Tax Act, investors can claim a deduction of up to ₹2 lakh for interest with an additional ₹50,000 for loans less than ₹35 lakh. Thus, tax benefits are significant for loans less than ₹35 lakh. However, for larger home loans, the effective post-tax rate falls by only a small decimal and does not translate into any significant savings. If you have a ₹2 crore, 20-year outstanding loan at 9 %, for a person in the 33 % tax bracket, the tax benefit is hardly .02% to 05% of the loan amount in the first few years.
The stock markets will make better returns: In theory, on the basis of interest rates and expected investment returns, investors should be able to make a rational decision about investing versus loan repayments. In reality, investors cannot predict both interest rates and expected returns from equities.
My friend took a ₹2 crore housing loan to buy his dream home in 2021 as the rate offered was a mouth-watering 6.5 %. The EMIs (equated monthly installments) were a small stretch, as they always are, but stock markets were booming and he decided not to liquidate his equity investments and take the huge loan instead. We all know what happened towards the end of 2021. In a matter of a few months, rates moved to 9 % and his EMIs increased by a whopping 20%. In the meanwhile, the stock market had started correcting. Understandably, he panicked, exited all the savings at the market bottom, and moved them to fixed deposits (FDs).
Having a huge mortgage to pay off makes you vulnerable. It will be mentally difficult to stay resilient during market falls. Secondly, there are too many variables in the investment thesis that can go wrong and against you in the short term—a long period of no performance, a massive crash, or an unprecedented rise in interest rates All this while you have an ongoing loan to pay or struggling with cash flows? Being debt-free or reducing debt is a 100% sure-shot strategy. You know what you will save and there are no ambiguous factors or risks that can affect your family.
Sense of security:There is a psychological comfort in seeing money available in the bank. So savings just sit in the bank or get invested in FDs. People do this despite having a huge housing loan on the side, simply because of the perceived comfort of safety and liquidity. If seeing money in the bank is your thing, a simple smart loan that offers an overdraft against your property should do the job. You don’t earn interest, but you don’t pay as much and that is a huge saving in interest costs. Losing money to taxes and inflation is a bad decision.
Insurance will take care of all contingencies: Life happens! Sickness, emergencies, divorce, or death, anything can happen along the way. Insurance can only cover known risks. When a client met with a traumatic accident, insurance covered his medical bills. His recovery however took over three years during which the family had to dig into savings. The one thing they were most grateful for was that they were debt-free. You can be frugal with every other expense but not with EMIs.
When you have a big loan, taking breaks and sabbaticals are unthinkable. On the other hand, being debt-free helps you take better risks with your career and hence improves the overall savings that you will be making. It will help you build the resilience required for long-term investments such as equities and ride out the volatility.
The stress of paying monthly loans and the fear of being unable to service the same should you lose earning ability, both have a deep psychological impact on your family and your life. Compare this with the mental peace and freedom of being debt-free. It is worth it.
Kavitha Menon is a registered investment adviser and founder of Probitus Wealth.
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Published: 20 Dec 2023, 10:12 PM IST