The Plainspeak / Loans

A belief · pairs with the Emergency fund calculator

Better off is not the same as ready

A loan prepaid from your savings makes the balance sheet look better on the day you do it. Whether you can pay next month's bills is a different question.

By 37xBetter · a banker's view

Using liquid savings to prepay a loan reduces debt and future interest. But it also converts accessible cash into a benefit you may not be able to retrieve when income stops.

The mechanism is asset-liability timing: being better off overall does not necessarily mean being better equipped to meet next month's obligations. A household can improve its balance sheet and weaken its immediate resilience in the same transaction.

Take a ₹50 lakh home loan at 8.5% for 20 years, with an EMI of ₹43,391, and a family with ₹6 lakh in the bank. In year 2 they put ₹5 lakh of it into the loan and keep the EMI the same. The loan now ends about 3 years 9 months early and they save about ₹14.6 lakh of interest, which is a very good result on paper. But the EMI next month is still ₹43,391, because a prepayment with the EMI unchanged shortens the loan and does not lower the monthly bill. If the family spends ₹60,000 a month besides the EMI, they need about ₹1.03 lakh every month, so the ₹6 lakh would have carried them for nearly six months without a salary, and the ₹1 lakh left carries them for less than one.

The bank does not give the prepaid money back when the salary stops. To get cash out of the house again you would need a top-up loan or a loan against property, which you have to apply for, which takes time, and which is hardest to get exactly when your income has stopped. So the money is safe from being spent, and also out of your reach.

None of this is a case against prepaying. It is a case for doing it in the right order:

1. Keep at least six months of expenses, EMIs included, in money you can reach within a day, before you prepay a rupee.
2. Prepay from what is left above that buffer, or from a bonus or a raise, and not from the buffer itself.
3. Keep a bigger buffer when income is about to become uncertain: before a job change, a sabbatical, a business start or a planned retirement, which is when people are most tempted to clear the loan and when cash matters most.
4. Check that term cover would clear the loan if something happened to you, so the family's buffer is not the only thing standing between them and the EMI.

Done in that order, you get both: a smaller loan and a household that can still pay its bills in a bad month.

A balance sheet is measured once a year. Bills arrive every month.