To OD or NOT to OD
Person A on twitter posted this:
A: Home loan OD is indeed a great hack. Stan Chart is one of the few banks that offer this. In my case, with another bank, I ended up parking more than the outstanding and the bank had to change their triggers to spot this. BTW, the amount parked in OD is also debt asset.
Person B raised this question:
B: You save interest on an OD loan (which is a depreciating liability), but you don't earn any profit either. What if we invest the lump sum (for the OD) and continue bearing the loan interest? Wouldn't that be more profitable? OD loan is probably one of the biggest financial myth.
Neil Borate NB responded:
NB: Depends on the return delivered by the investment vs loan interest rate post tax benefits.
To which the Person B responded:
1 cr loan for 10 yrs @ 9 %, interest paid is 52L. On the date of loan disbursement, if 1 cr in invested for 10 yrs @ 8%, total gain would be 1.15cr. One can avail sec 24 rebate with joint loan in old scheme or on rented property in new tax scheme.
Is this a valid though process by person B? Let's examine with a loan amount of 1 cr.
Now the whole premise of the situation is that you don't actually need the 1cr loan - if you did you would not be able to invest it or park it in the OD account (since you would use it to buy the house) - making the above comparisons pointless. This is very important to grasp as the whole calculation hinges on it and some people may miss this very simple but crucial point. To help understand this differently, you may even consider a situation where maybe you have taken a 4 cr loan when you need only 3 cr. so the question really is about what to do with the 1cr.
To be able to compare, we will work with a closed box of -> this 1 crore is all we have and there are no additional external funds available. Without this assumption, the comparison will be unfair OR far more complex. Let's move ahead with this understanding. Now, let's say you take a 1 cr loan at 9%. Scenario A: You put the 1 cr back into the OD account. Use it as an emergency fund etc. or use it to invest when there is a major market crash. Whatever. If you never pay interest then your only cost is the various loan processing fees at the start of the loan. I know people who keep emergency funds of 40-50L but you could extend this logic to a smaller loan amount (50L loan and 25L emergency fund). The amount does not matter - the logic does. Scenario B: You invest the 1 cr in an FD giving 8%. In scenario A - If you pay an EMI, you can transfer it back to your OD account to your savings account the very same day. This is because your principal outstanding reduces since the entire EMI is principal repayment - no interest. You don't have to pay any interest ever and effectively no EMI. In scenario B - Take 1 cr loan and park it in an FD. You will pay an EMI each month - some of it will be interest and some will be principal repayment. So this cash has to come from elsewhere, which is not the case in scenario A. Since we started off with the assumption of a closed box, we cannot inject external cash - but we can withdraw the EMI from the FD and pay off the EMI. This will dramatically reduce the FD returns. The math for this requires one to do a reducing balance interest calculation but common sense tells us the FD returns will be extremely low. Person B is making this very fundamental mistake of assuming that EMI has to be paid in both case. This is not true. Of course, if you choose a riskier instrument for investing the 1cr, returns could be higher than FD. And returns will vary depending on the tax benefits available, which is exactly what Neil Borate said. Not to mention the fact that 8% return from FD is not a good assumption. Perhaps 7% is more realistic. To give an example of why individual tax situation is important - for someone in the 1 cr + salary bracket, FD returns are 4.5% or lower. And if you are withdrawing from this corpus to pay EMI, then returns will become abysmally low (negative, I suppose). There are many people who have already maxed out on equities and like to stay diversified across other asset classes such as debt, cash, real estate, commodities etc. as OD loan can be a perfectly valid option for them. This why there is no such thing as "OD loan is probably one of the biggest financial myth." It completely depends on your personal situation and I'd wager that in a large number of cases it is a good idea. Personally speaking, I'd happily use an OD loan account to the extent where I can park my emergency cash (roughly 2-3 years of living expenses) plus some buffer and pay off the rest of the loan. With financial products where large amounts are involved, it's important to validate and then re-validate your assumptions esp. if you are not financially very savvy. The following statement does not even pass the smell test: "1 cr loan for 10 yrs @ 9 %, interest paid is 52L. On the date of loan disbursement, if 1 cr in invested for 10 yrs @ 8%, total gain would be 1.15cr." How can the total interest to be paid on a 9% loan (taken from the bank) be more than that on a 8% loan (given to the bank)? This should make you pause and think, and evaluate where you are making bad assumptions. Hope this is useful. <TBD: Will elaborate further with calculations if I have time>
No comments:
Post a Comment