If you are just starting career after graduation or are a young professional or a middle-aged executive, it is likely you will have to decide on whether to prepay an outstanding loan using savings. In this article, we discuss the behavioural aspects to prepaying loans, including how to optimally balance emotional concerns with returns.

Emotional concerns

Outstanding loans cause anxiety for most individuals. Small wonder many prefer to prepay their loans. While this saves interest costs, using savings to prepay a loan forces you to give-up interest income. It is typically true the interest cost saved is greater than the interest income lost. So, there is net savings and lower anxiety, if not emotional relief. So, why then is the decision to prepay not so simple?

For one, prepaying may not allow you to enjoy full tax benefits on interest payments. For instance, if you were to prepay home loan such that the interest payment is more than ₹2 lakh in a year, you may be unable to claim benefit for the entire interest payment. For another, prepaying a loan could lead to unintentional spending. Suppose, your lender keeps the same tenor (period of the loan) but reduces the monthly instalment based on the prepayment amount, say, from ₹35,000 to ₹28,000 starting next month. What will you do with the ₹7,000 that was otherwise earmarked for the loan repayment?

If you do not make a conscious effort to save, the additional cash flow will become part of regular household expenses! Importantly, cutting expenses later may not be easy when you want to raise savings. So, prepayment could lead to a rise in expenses and decrease in savings. You must, therefore, plan to invest the additional cash before prepayment.

Conclusion

The simplest way to avoid unintentional rise in spending due to loan prepayment is to set up an investment starting from the revised instalment date. Suppose your bank revises instalment amount from next month, you must set up a systematic investment plan (SIP) today that starts next month. Your investment can be in the same product which you liquidated to prepay loan or could be a combination of a recurring deposit and an equity fund of your choice. The new investment could be earmarked for a new life goal or can supplement an existing life goal that needs more contribution.

(The author offers training programme for individuals to manage their personal investments)

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