What should I do with my surplus money?

Ramesh Sharma is in a tizzy. The company where he works has showered an unexpected hefty bonus on him. Coming after two years when the going was tough and salaries were cut, the 34

What should I do with my surplus money?

Ramesh Sharma is in a tizzy. The company where he works has showered an unexpected hefty bonus on him. Coming after two years when the going was tough and salaries were cut, the 34-year-old father of two young kids is unable to decide how to utilise this mannah from heaven. Minus the holiday he had planned for the family, the choice is between partial prepayment of one of the loans riding on him and a fixed deposit. Sharma has a 20-year home loan that he took five years back and a five-year car loan that he availed two years back just before the economic slowdown kicked in. For Sharma, the agonising experience of the last two years is still fresh in his mindhow he toiled and was somehow able to make ends meet for the family. At one stage, he even borrowed money from friends to avoid a default on the home loan installment. Sharmas case is not one-off . There are lakhs of salaried individuals today facing a similar dilemma. To help you make your decision, heres a guide on prepayment approach.

When to prepay

The simplest answer to this question iswhen one has surplus money. Yet it has been seen that people do not prepay even if they have sufficient funds. The trigger generally is a windfall gain, say in the form of an annual bonus, sale of a house or securities that makes people think about reducing the baggage. If theres a delay in the decision, people either end up spending the one-off amount on buying lifestyle products and holidaying or park the funds at a place where they think it can grow at a healthy pace.

The ideal scenario, tax experts say to pay-off partially or completely should be when you have a floating rate loan and the interest rate is growing in the market. A high interest rate situation is bad for your pocket, as it not only increases your loan tenure but also the total outgo. It makes maximum damage in cases where the term goes beyond your earning age. Heres an example of how prepayments can actually lessen your liability. Say you have a home loan of Rs 10 lakh for 20 years at an interest rate of 12%. Under normal circumstance , you would end up paying a net interest of Rs 16.43 lakh. Yet, if you chose to use your surplus money to pay two additional installments every year, you will be able to wrap up the loan in 13 years. Thus, you finish up paying a total interest of only Rs 9.81 lakh, instead of 16.43 lakh. Here the key is your cost-benefit analysis keeping in mind whether substantial additional tax benefits are available under Section 80C. Theres even a misconception that home loans should not be prepaid, as the interest component decreases as the loan matures. Thats not the case. The interest is calculated on reducing balance method, which means the percentage of interest of the outgo always remains the same, says Robin Roy, associate director, PricewaterhouseCoopers (PwC). So, if you can afford to make larger payments towards your home loan, perhaps because of a promotion or a bonus or other windfall gains, then prepay to save money over the term of the loan.

How to self evaluate

As a first step, you should approach your bank to understand if they permit prepayment of loan and if the same is permitted in parts and charges or penalties are attached thereto. Then you must keep aside some money in the form of investments to mitigate the risk of unforeseen contingencies . A cushion of savings before repaying the loan is an absolute must. A calculation should be made on the net rate at which you are paying interest after accounting for tax breaks. After which a checkout should be done on the net returns you expect to earn on the funds to be used for prepayment. So, if the net return on investments is lower than the net rate of interest on the loan, then the decision to prepay makes sense. Here, its essential to factor in prepayment charges or penalties, if any, as they should not exceed the savings in interest cost, says Gaurav Karnik, associate directortax and regulatory services, Ernst & Young, advising further that you must look at the opportunity of negotiating these charges.

On the other hand, if you have taken a loan on fixed rate of interest, lower than prevailing interest rates, or if you enjoy sizeable tax benefits in respect of principal, you must work out the pros and cons before taking a final call. In case you are servicing multiple loans such as a housing loan, vehicle loan, personal loan and others and have to make the choice to repay, it is advisable not to give top priority to the former. Housing loans are long-term loans and as such an overall increase in interest rates would have a much lower impact on the cash flow as compared to car loans or personal loans which are generally shorter duration loans, explains Renu Sud Karnad, managing director of Housing Development Finance Corporation (HDFC). What makes housing loans a better deal is the greater tax benefits attached that lower the effective interest rate.

Ideal tenure

For starters, the tenure for home loans usually varies anywhere between 5-20 years. Tax experts say the first criteria to decide on the tenure of home loan should be to assess your disposable income. If net disposable income is low, one must opt for a longer tenure loan, even if you would be required to pay interest for an extended period. Since the loan amount is spread over a longer period of time, immediate burden on you would be low, says Karnik of E&Y . Moreover, future income must be factored in. If you are likely to retire in the near future, the tenure shouldnt be stretched beyond your retirement age, says Karnad of HDFC. Going by the thumb rule, for a 30-year-old , longer tenure loan, stretching up to 10-20 years is a better option , as gradually the persons income would rise. Interest cost is another component you must bear in mind. Short-term loans typically attract lower rates of interest as compared to long tenure loans. So, if you have enough liquidity and resources to repay loans, shorter duration loans must be favoured. Another factor influencing loan tenure would be the loan amount. Your loan amount often determines whether you should opt for a longer or shorter duration borrowing. Where the borrowed amount in question is huge, longer tenure loans make better sense.

Read More News onRamesh SharmaPricewaterhouseCoopersErnst & YoungHousing Development Finance CorporationRobin Royassociate director

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