Just after you bought that Kindle and said yes to convert the credit card outstanding into equated monthly installments, you realize that you have several parallel loans running. Home, car, gadget and even on that Levi’s you just had to buy. Ever wondered if there is a prepayment heirarchcy that you can follow? Should you decide to do the right thing and begin prepaying loans, instead of taking the bonus and going for a Bali holiday? Here’s a strategy for deciding which loan to prepay first.
Costliest loan first:
“Costliest loans, such as credit card should be paid off first,” says Jaishank Gupta, certified financial planner, Sykes and Ray Financial Planners, a Mumbai-based firm. There is no doubt that credit card debt is the most expensive, with rates as high as 45% per annum. Even within cards there is a heirarchy—pay off those that carry the highest rates of interst. Here’s something to remember: If you keep paying only the minimum amount due and keep rolling the credit, it would take you around seven years to pay off a balance of just Rs 5,000.
Loans without tax benefits
The next loan that should draw your attention is a personal loan or a car loan, whichever is more expensive. The current rates of interest on a personal loan are touching 28% per annum, but there are times in the interest rate cycle when these dip to about 13%. If you are sitting on a car loan of 15% at that point, it would make sense to pay off the car loan first and then tackle the personal loan. But remember that the car loan may come with a prepayment penalty, usually 2% or as high as 5%. In such a case, it does not make sense to prepay a car loan. Both these loans offer no tax benefit and should be paid off if interest rates rise too high. “High interest rate loans which do not offer a tax benefit such as a credit card and car loan should be paid first,” says Gupta.
Also See | Prepayment hierarchy (PDF)
Loans that offer tax benefits: Once you’ve taken care of costlier loans which do not offer any kind of tax benefits, then look into loans that offer a tax benefit. The tax benefit makes the effective interest rate lower.
Jayant Pai, certified financial planner and vice-president, Parag Parekh Financial Advisory Services Ltd, says, “Education loan is not a very expensive loan and also offers income-tax benefit, hence it must be paid after the credit card, personal loan and car loan.” Interest rate on an education loan may vary in the range of 13-14% per annum, so it must be paid before a home loan which usually carries a lower interest rate and higher tax benefit. In terms of tenure and interest rates, education loan falls between car and home loans. For an education loan, you are eligible for a tax deduction under section 80E of the Income-tax Act. You get the benefit of tax deduction on the interest part of the loan you pay. Though, you will be not get any tax benefit on the principle repayment of the loan, there is no cap on the deduction amount for the interest amount you pay.
Home loan: The last loan you prepay is the home loan. This loan runs the longest, usually for 15-20 years. Ranjit Dani, a Nagpur-based certified financial planner, says: “It is a long-term loan and it also gives a tax benefit on both the principal as well as the interest amount.” Under section 80C of the Income-tax Act, the principle repayment of up to Rs 1 lakh can be used as a deduction. Under section 24 of the Act, you can get deduction up to Rs 1.5 lakh for interest payment. In fact if you hold the house jointly with your spouse, both of you can get tax benefits for the principle as well as the interest amount. And if you rent the house out, the entire interest amount you pay is tax deductible. A high net worth borrower should not prepay the home loan, especially during high inflation, since it brings the real cost of the loan down to almost zero as inflation reduces the value of each rupee of the equated monthly installment.
Things to keep in mind: “Two things to keep in mind while choosing the prepayment hierarchy is: first, the cost of the loan, as in the interest rate, prepayment penalty if any; and second, the tax benefits on the loan,” says Pai. Remember that most financial planners say that prepaying any loan is always a good idea to reduce risk in your financial life. In case you cannot prepay the entire loan amount in one shot, it still makes sense to prepay at least a part.
Illustration by Jayachandran/Mint