Aditya had recently returned to India after a successful banking career in London. A few months after settling down in Bengaluru, he purchased an apartment in a well-appointed gated community by availing a home loan. Aditya’s impressive performance at work earned him a sizeable bonus a year later. Like many salaried professionals, he faced the dilemma of choosing between reducing his loan or investing the bonus.
If Aditya had invested ₹20 lakh in equity, earning 12% annually over 10 years, his investment would have grown significantly and delivered higher absolute returns than prepaying the loan.
Theoretically, the answer appeared obvious. The choice between loan prepayment and investing boiled down to the difference between what he saved in interest cost by reducing the loan, and the expected return he would earn by investing the bonus.
Aditya’s home loan cost 8%, while the expected long-term return on equity was projected at around 12%, providing him the opportunity to earn the difference between equity growth and mortgage cost. But the comparison is not fair. Expected returns are just that—expected, not guaranteed, as the returns can vary meaningfully over time. Aditya’s reduction in interest costs is guaranteed.
Just as companies use balance sheets, income statements and cash flow statements to measure financial health, so can households. A household’s balance sheet comprises assets and liabilities. Assets include financial and non-financial investments, as well as money owed to the household.
Liabilities include loans, credit card payments and other fixed obligations owed by the household. When liabilities increase, a larger part of the monthly income goes towards servicing liabilities. The ability to create assets gets constrained, causing a growing mismatch between assets and liabilities over time.
A household’s cash flow statement tracks its cash flows over a period. Cash inflows include salary, other income, rent or returns on investments. Outflows comprise various expenses, including loan servicing. Expenses can further be classified as mandatory, essential and discretionary.
Loan servicing falls under mandatory payments. In times of adversity, one can eliminate discretionary expenses and, to an extent, squeeze essential expenses, but there is little flexibility to reduce mandatory expenses. A large loan is therefore risky when the ability to service it over a long time horizon is compromised.
Carrying a home loan thus creates inflexibility and fragility in a borrower’s balance sheet. By keeping the loan, he retains a larger EMI, commits future cash flows, and becomes dependent on stable employment and favourable market outcomes. The loan obligation remains constant while the investment portfolio can sharply correct, causing a mismatch between assets and liabilities.
By reducing the loan, Aditya would lower his EMI and free up monthly cash flows. If he chose to invest even a fraction of that monthly savings consistently, he would continue building assets while carrying lower financial obligations. This is a less fragile balance sheet.
A prolonged volatile market correction or an untoward financial or personal situation can force tough decisions at the most inopportune time. Volatility is stressful, even without leverage. With leverage, the disruption is magnified because fixed obligations do not wait for markets to pick up.
The risks associated with servicing a loan can only be partially mitigated through life insurance in the event of the borrower's death. However, other risks persist due to job loss, disability, medical emergencies, prolonged market corrections, inadequate safety in the portfolio, or impending goals that require immediate redemptions.
In the old tax regime, carrying a home loan was easier to justify because part of the interest and principal repayment translated into tax savings. In the new regime, that argument has weakened considerably. Once the tax advantage disappears, interest becomes a direct, full cost expense.
Over 10 years, the total interest paid on a ₹1 crore loan at 8% is about ₹46 lakh. Reducing the loan to ₹80 lakh lowers the interest to about ₹36 lakh.
Hence, by prepaying ₹20 lakh, you save ₹10 lakh in future interest cost. This return is guaranteed, tax-free and unaffected by market conditions.
Having weighed his options, Aditya decided to reduce his home loan instead of investing the bonus. A ₹1 crore loan at 8% over 10 years carried an EMI of roughly ₹1.21 lakh a month. By reducing the loan to ₹80 lakh, his EMI fell to about ₹97,000.
The ₹24,000 difference each month may seem insignificant at first. But over a decade, it creates a meaningful buffer to absorb sudden expenses, continue investing towards future goals, and avoid excessive reliance on income growth to fund growing consumption requirements.
Equity investing will continue to create wealth into the future. But when the spread between borrowing costs and expected returns narrows, balance sheet strength is just as important as portfolio returns, if not more.
Priya Sunder is director and co-founder at PeakAlpha Investments. Views are personal.