The banking industry is a very funny one – whose basis for lending is that of insecurity. A smart individual investor can use it to his advantage to create wealth. In a consumption oriented and growing economy, most households have some exposure to debt of some kind – the most common being housing loans and car loans. A lot of popular advice or propaganda is centered around how much loans to take, how to save for down payments, how to negotiate on interest rates, how not to get under the debt burden, etc. Also further on how a housing loan makes sense, a car loan may be ok, but personal loans and credit card loans are avoidable. These are all valid topics and important micro advice, things to be carefully considered before one goes out and borrows. But for an individual investor who gets caught up in them too much, they can be akin to focusing on the small stuff and missing the bigger picture; focusing on data and information, missing out on knowledge and wisdom. A lot of that big picture view about loans and their prepayment that might be very important, and something that is structural.
Fundamentally, as I said, the banking industry is based on the premise of insecurity. Let me elaborate. It wants to give money out because it is in the business of lending and making money out of it. So it wants to make sure that its capital is safe when lent to someone. Hence it has processes to evaluate credit worthiness of individuals, and depending on the stage of the economic cycle, that process either gets lax or becomes stringent. But further to that, once the creditworthiness is established, the way a bank or any lender makes money is through the interest the borrower pays. So it also wants to make sure that it is going to get the interest. Which means it does not want too much of prepayment, else it loses out on interest and its profits may come down. Hence it comes up with two mechanisms – one, it collects most of the interest in the initial parts of the loan tenure when it assumes that most borrowers are unlikely to prepay, and two, it charges penalties on prepayment anytime during the loan tenure. That’s the reason it is playing to balance two types of insecurities. The first insecurity is that of principal repayment or fundamentally loss of capital, and the second insecurity is loss in collection of interest. Its security against loss of capital is processes to evaluate credit-worthiness and mortgage or hypothecation of the asset i.e. housing or vehicles. And its security against loss of interest is prepayment penalties or general discouragement of too much prepayment. An individual investor who understands this can take advantage of this insecurity of the lender to build wealth.
So what is the way? The way is simple. The trick is to put a slightly lesser amount in down payment than you can afford to, take a higher loan initially, negotiate no prepayment penalties, and save more cash in the early loan tenure to prepay part of the principal. How does this help? The structure of most loans is such that if you do not prepay in the first few months or years, the interest gets collected by the lender via the installments. The key for an individual is to ensure that larger part of that installment is going towards principal rather than interest. That never happens when it is most needed i.e. in the initial tenure of the loan. The traditional advice given is if you can earn more than the interest rate on your loan through other means, do not prepay, specially on a housing loan – where reasons such as it is an appreciating asset and you get income tax cuts are provided as further reasons on why not to prepay. But that is exactly what works to the advantage of the lender rather than the borrower. If one looks at the structure of a loan, it is not about interest rate, but about absolute interest that you pay in the first few years. You may be paying a uniform interest rate, but collection of the interest amount is not uniform – it is skewed in favor of the lender. So even if you garner more returns than the rate of interest on your money through other means of investment, the bank has already collected the interest early. The borrower’s returns on money not prepaid will compound only after a few years once capital and returns accumulate, but the bank’s interest gets paid early in the tenure. So if the borrower prepays early, he stops compounding of that interest for the lender early on by reducing the capital outstanding. This gets even better for depreciating assets like cars where interest rates are higher, and the asset is depreciating – so you are essentially paying interest for asset usage and left with some small residual value.
There are no two ways about it. For the borrower, the effects of early prepayment even in small amounts are unequivocally positive, and can be almost magical in terms of interest savings. A borrower can check amortization calculators to check on the impact – it definitely is more than what most individuals expect. And if one has managed to buy an appreciating asset at the right price, has a reasonable loan to value ratio, and low EMI-to-income ratio, it is a sure recipe for creation of wealth over the long run at the expense of the lender.
The trick is in managing that well. The financial industry will try its best to trap borrowers with a high loan to value, high EMI-to-income ratio, and high prepayment penalties – which means a borrower will have no option but to keep paying EMIs regularly for a long period – by which time the lender has collected interest and made money on your loan. And after which point, there is no logical incentive to prepay as the loan has now become cheaper. The risk of the loan for the lender is gone. The trick is to be in a position where you can prepay early in the tenure, and let compounding of interest (or lack of it in this case) work for you rather than against you.
