Unlike those of previous generations, and more like in western nations, many Indians these days do not avoid loans. In fact, they are more than comfortable carrying a few of them at a time.
But being free of debt is a good feeling. It offers mental peace. So, what to do if you too are sailing in the multiple-loan boat but want to become loan-free soon?
Taking an example here would allow for an easier explanation.
Suppose you earn ₹1.5 lakh monthly. Over a period of time, you have gradually become laden with a few debts. To name them, these are:
- Home loan ₹50 lakh for 25 years at 8% with EMI ₹38,591 per month
- Car loan ₹8 lakh for 5 years at 10% with EMI ₹16,998 per month
- Personal loan ₹3 lakh for 3 years at 13% with EMI ₹10,198 per month
- Credit Card dues ₹1 lakh @ 3% per month (Or 36% annually)
You are regularly paying total EMIs of close to ₹65,787 for a home loan, a car loan and a personal loan. So, from a monthly income of ₹1.5 lakh and assuming regular expenses of ₹60,000 per month, it leaves about ₹24-25,000 per month in surplus. This is assuming (theoretically for this example) that there are no savings to be made.
So how can you use this surplus of ₹25,000 per month if you want to begin loan prepayment? And if all of it has to go to prepayment, then which loans to tackle first?
The answer is simple and mathematics driven.
Go for the loan or dues that have the highest interest rate.
And in the above example, it’s your credit card dues which cost about 36% annually. Far more than your personal or car loan.
You have ₹1 lakh in card dues. Ideally, one should pay off the dues in full before the due date. But if that’s not possible, then try to pay it as soon as you can and before you start prepaying other loans.
Considering the ₹24-25,000 in monthly surplus, you can clear off the card dues of ₹1 lakh in 4-5 months’ time.
Once that is done, you should then pick the next highest interest-bearing loan – which is a personal loan at 13%. And once that is cleared, only then you should pick up the next loan in the interest rate hierarchy – your car loan.
Is there a better way than this?
Your credit card interest rate is close to 36%. Your personal loan costs you 13%. So, there is a case for taking another personal loan! Yes. You read that right. But why? You can take another personal loan of ₹1 lakh, which is equal to your card dues. You then use that money to fully pay off your card dues in full.
This makes sense. And that is because even though you still have the same outstanding loan amount, the cost of that is much lower at 13% (due to personal loan) than what it was in the case of credit card (36%).
But is it right to use the full surplus to prepay loans or should you invest something too?
This is a dilemma that many have.
But if you have your emergency fund in place, then a possible strategy can be to try to pay off the credit card and personal loan quickly. Home loans can still be continued regularly as they have much lower effective post-tax rates. Car loan rates vary quite a bit at times. So, if it’s not very high, then one can consider running it regularly.
That said, let me say something which all borrowers should keep in mind.
Just because you have the ability (a sufficiently high income) to take many loans and service EMIs doesn’t mean you should take them. After all, you have to repay the loan and it’s not free. It costs interest. So, it’s fine to borrow judiciously and for your needs. But don’t borrow unnecessarily and for discretionary avoidable expenses.
Dev Ashish is a SEBI-Registered Investment Advisor and Founder (Stable Investor). He provides fee-only financial planning and investment advisory services to small and HNI clients across India.