TomorrowMakers ™

Financial Planning

Ever heard of loans that help you save money?

20 June 2016
The pressure of having to repay a loan, with or without EMIs, can be immense. But did you know that some loans can help you pay off other loans and save money in the process?
 

When you opt for a home loan, you pay a significant down payment and commit to EMI payments for the next 20-25 years. A vehicle loan leads to EMI payments along with the added cost of owning and maintaining the vehicle. Personal loans too will result in high interest payments for 3-5 years. The common theme in all these loans is the outflow of money.

In such a scenario, the idea that loans can actually help you save money may seem too good to be true. Well, this can be done in two ways.

A cheaper loan to repay a costlier loan

 

Original

New Loan - I

New Loan - II

Loan amount

Rs. 5 lakhs

Rs. 5 lakhs

Rs. 5 lakhs

Interest rate

22%

16%

16%

Tenure

5 years

3 years

5 years

Total interest payment

Rs 3.4 lakhs

Rs. 1.5 lakhs

Rs. 2.4 lakhs

The new loan is significantly cheaper than the first loan. Due to the interest rate difference, you will save Rs. 2 lakhs by using the second loan to repay the first loan despite the shorter tenure. Even if you let the second loan run for five years, you will still save Rs. 1 lakh as compared to the original loan.

How can you qualify for a lower interest rate?

You can take advantage of a fall in interest rates to switch to a cheaper loan. Or, you can switch to a bigger lender offering personal loans at a significantly lower rate and repay the existing high-interest loan. The third option is to get a secured loan to close an unsecured personal or automobile loan. Fourthly, you may consider shifting your job, because even your employer’s profile have an effect on your personal loan eligibility and rate of interest being offered.

Related: How your employer affects your loan eligibility

A shorter loan to prepay a long-term loan

The second option is to make prepayments to a long-term loan such as a home loan.

 

Home Loan

Short-Term Loan

Loan amount

Rs. 50 lakhs

Rs. 2 lakhs

Interest rate

11.2%

16%

Tenure

25 years

3 years

Total interest payment

Rs 1.02 crores

Rs. 60,000

A look at the amortization schedule of a home loan taken in June 2016 shows how a one-time prepayment of Rs. 2 lakhs in the fifth year will lead to reduction of interest cost by Rs. 15 lakhs

No prepayment

Year

Principal

Interest

Total Repayment

Balance O/s

2016

Rs. 22055

Rs. 3,26,057

Rs. 3,48,112

Rs. 49,77,945

2017

Rs. 41312

Rs. 5,55,452

Rs. 5,96,764

Rs. 49,36,633

2018

Rs. 46184

Rs. 5,50,579

Rs. 5,96,763

Rs. 48,90,449

2019

Rs. 51630

Rs. 5,45,134

Rs. 5,96,764

Rs. 48,38,819

2020

Rs. 57719

Rs. 5,39,044

Rs. 5,96,763

Rs. 47,81,100

2021

Rs. 64526

Rs. 5,32,237

Rs. 5,96,763

Rs. 47,16,574

2022

Rs. 72135

Rs. 5,24,628

Rs. 5,96,763

Rs. 46,44,438

2023

Rs. 80645

Rs. 5,16,121

Rs. 5,96,766

Rs. 45,63,795

2024

Rs. 90153

Rs. 5,06,610

Rs. 5,96,763

Rs. 44,73,642

2025

Rs. 1,00,787

Rs. 4,95,979

Rs. 5,96,766

Rs. 43,72,857

2026

Rs. 1,12,671

Rs. 4,84,091

Rs. 5,96,762

Rs. 42,60,186

.

.

.

.

.

.

.

.

.

.

2038

Rs. 4,29,335

Rs 1,67,428

Rs 5,96,763

Rs 12,58,375

2039

Rs. 4,79,968

Rs 1,16,795

Rs 5,96,763

Rs 7,78,407

2040

Rs. 5,36,570

Rs 60,192

Rs 5,96,762

Rs 2,41,836

2041

Rs. 2,41,835

Rs 6,813

Rs 2,48,648

Rs 0

 

One-time prepayment

 

Year

Principal

Interest

Total Repayment

Balance O/s

Prepayment

2016

Rs. 22055

Rs. 3,26,057

Rs.  3,48,112

Rs.  49,77,945

Rs. 0

2017

Rs. 41312

Rs.  5,55,452

Rs.  5,96,764

Rs.  49,36,633

Rs. 0

2018

Rs. 46184

Rs.  5,50,579

Rs.  5,96,763

Rs.  48,90,449

Rs. 0

2019

Rs. 51630

Rs.  5,45,134

Rs.  5,96,764

Rs.  48,38,819

Rs. 0

2020

Rs. 57719

Rs.  5,39,044

Rs.  5,96,763

Rs.  47,81,100

Rs. 0

2021

Rs. 77963

Rs.  5,18,799

Rs.  5,96,762

Rs.  45,03,135

Rs. 2,00,000

2022

Rs. 97307

Rs.  4,99,458

Rs.  5,96,765

Rs.  44,05,828

Rs. 0

2023

Rs. 1,08,784

Rs.  4,87,983

Rs.  5,96,767

Rs.  42,97,046

Rs. 0

2024

Rs.   1,21,612

Rs.  4,75,151

Rs.  5,96,763

Rs.  41,75,434

Rs. 0

2025

Rs.   1,35,954

Rs.  4,60,810

Rs.  5,96,764

Rs.  40,39,481

Rs. 0

2026

Rs.   1,51,985

Rs.  4,44,778

Rs.  5,96,763

Rs.  38,87,494

Rs. 0

.

.

.

.

.

.

.

.

.

.

.

.

2038

Rs. 4,17,374

Rs. 19,319

Rs. 4,36,693

Rs. 0

Rs. 0

As you can see, there is a sharp fall in the interest cost after you make the prepayment. You can reduce the tenure of the loan by 2 years and 8 months and end up saving a tidy sum of Rs. 15 lakhs on the total loan repayment.  

If you borrow Rs. 2 lakhs and use the same to make a one-time prepayment in the fifth year of your home loan, then your total interest cost will come down by Rs. 15 lakhs. The total interest cost on the short-term loan will be just Rs. 60,000, which means you will actually save Rs. 14.4 lakhs by borrowing more money.

This is possible because less than 10% of the EMIs paid in the second year go towards reduction of the outstanding principal.

 

Year 2 (approx)

Year 20 (approx)

Annual Repayment

Rs. 5.97 lakhs

Rs. 5.97 lakhs

Principal Repaid

Rs. 41,000

Rs. 3.07 lakhs

Interest Paid

Rs. 5.55 lakhs

Rs. 2.89 lakhs

As you can see, the principal owed comes down faster in the later years of the loan. So, borrowing money and making a one-time principal repayment on your home loan will help you save a lot on interest charges However, taking a fresh loan and committing to EMI payments has its own set of risks. A safer alternative would be to pay an extra Rs. 5-7k over and above the monthly repayment. This requires more financial discipline but helps you avoid taking a fresh loan and paying interest on the same.

Related: Have an outstanding home loan amount? Get equivalent life cover

So, are you wondering about the catch or the hidden complication in the transaction? There is no catch. You can save money provided you choose the right loan like loan against shares, mutual funds, gold, property, or even land. These are secured loans offered at low interest rates with quick processing and formalities similar to those you completed when finalizing your home loan. To know more, here is Financial steps to take before major milestones: House [Infographic]

Benefits of Loans against Securities/Gold/Real Estate

  1. These are secured loans i.e. the lender has the option of selling the asset in case of default. The secured nature of the loan will automatically help you borrow money at much lower rates. Interest rates for personal loans range around 14%-22% per year. The rate for gold loan can be as low as 12% and is unlikely to be higher than 15%-17% if you shop around for the right lender. Low interest rate automatically translates into greater savings.
  2. These loans don’t have too many onerous restrictions as far as usage of funds is concerned. You can use the money to repay a costlier loan or reduce the term of a long-term debt. You can also use this as a source of funds for your business, which will help you earn profits and make repayments quickly.
  3. Being secured, these loans are easier to obtain and involve very few formalities. Loan against gold or securities are normally processed within 1-2 business days. Loans against real estate may take more time but delays can be avoided by ensuring all documents related to the property are in order.
  4. A very significant benefit of such loans is that you continue to enjoy the benefits of increase in the value of these assets despite the pledge. If share prices or gold prices or price of land appreciate, then you will automatically enjoy the benefits of such rise after repaying the loan in full.

Related: When Is It A Good Idea To Take A Top Up Home Loan?

Despite these benefits, there are some risks involved in such loans. Firstly, you will have to pay another EMI, especially if you are using a loan against gold to make a home loan prepayment. You should be in a position to bear the additional strain on your finances.

Secondly, a sharp fall in the value of the asset may lead to demand for additional payments by the lender. This problem is unlikely to arise if you opt for safe valuations and don’t over borrow. Yet, this is a risk that cannot be ignored.

Loan against assets, if used smartly, can help you save a lot of money with minimal risk and very little additional strain on your finances. Instead of letting your assets lie idle, you can use the same to boost your wealth through early closure of loans or through profitable new ventures. 

Each option described above helps you save money that would have otherwise ended up as interest or principal repayments to the lender. Each and every rupee saved can be invested in low-risk investments to generate additional returns. Saving money and investing the savings smartly is the simplest and safest way to become wealthier.

 

 
 
 
 

"An investment in knowledge pays the best interest"

- Benjamin Franklin -

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