Inflation-adjusted returns a must when leveraging assets

Aniruddha Chowdhury/Mint
Aniruddha Chowdhury/Mint

Please advise on my plan to reduce and close my home loan. The outstanding amount is Rs80 lakh with 20-year tenure starting this month. I have to pay back Rs1,96,86,442 at an average interest rate of 10% per annum. I earn around Rs2.25 lakh and my wife about Rs55,000 per month. I have mutual fund investments worth Rs13 lakh, stocks worth Rs13 lakh and 10 years of Employees’ Provident Fund Organisation (EPFO) contribution worth Rs35 lakh. The EPFO allows withdrawal of funds for loan closure after 10 years.

Here is my plan:

My EPF deduction will continue and i can recuperate the closure in 5-6 years. I invest Rs10,000 via systematic investment plan (sip) per month for my 5-year-old son’s education, which will continue. I would make a lump sum payment of Rs55 lakh with stock, mutual fund and provident fund (PF) money by August 2017.

—Hariharan Narayanan

Leveraging assets inflates their cost price as the inflated price (including the cost of leveraging) is used to calculate the yield on the asset. The cost of an asset, or calculating the yield, need not be done for all assets, for example: buying your first house for self occupation or buying a car. Still, it is useful to know that the house priced at Rs80 lakh actually costs you around Rs1.55 crore, with interest of Rs74.74 lakh (interest assumed at 10% for 15 years). Likewise, for a car priced at Rs7 lakh—with the complete amount financed for 5 years at 10%—you would have paid around Rs8.92 lakh. Now, these calculations are not meant to sway you from the decision to buy, but to give you a new point of view when planning to buy or invest in a new asset. At the same time, it helps to know how leveraging can be used to your advantage. For example, it will be very difficult for most people today to buy their first house without leverage.

In your case, first, we need to check the kind of asset we are buying. As mentioned above if the nature of the asset is depreciating in nature then the loan, if taken, should preferably be on the lower side. And this is when we are not even considering any tax benefits. In case the asset is a growth asset, such as a loan for a house, then leveraging can be considered. However, some things need to be kept in mind.

What is the current yield on the investment, which will be alternatively used to buy real estate? If the yield on the existing investment is higher than your cost of borrowing, then it makes sense to continue with the investment rather than reinvesting in real estate.

In your case, if the cost of borrowing is 10%, then this becomes the decision point. An investment that returns above this, should be retained. Any investment that returns below this, should be used to buy real estate or bring down the loan amount. Again, we have not considered the tax benefits of a housing loan. But it would be prudent to calculate the real return of the investment as well as the interest on a housing loan.

It is good to use PF deposits to prepay a housing loan, but continue with your mutual fund and stocks, as the expected yield on them is higher than 10%. Remember that any investment with a return of 10% or more will carry some risk. But as your horizon is 20 years, such risks could deliver inflation-adjusted returns. Ensure that your family is covered for the loans with adequate term insurance to safeguard them against any loss of life.

Surya Bhatia is managing partner, Asset Managers.

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