Which loan to pay back first?

Or, why prepaying a home loan to take a car loan isn't such a good idea

MUMBAI: Anand Verma returned home rather early one day and quickly slipped into the bathroom for a shower after handing over an envelope to his wife. When he came out, his wife was sitting on the bed with a quizzical expression on her face. She had read and re-read the cheque for Rs 5 lakh the envelope contained many times over and wanted to know what it was for. "It's my annual performance bonus sweetheart," he proudly told her, "All ours."

His wife's excitement was to be seen. Oh, the things she would buy with it!

But, Verma had other plans. He had a 20-year home loan that he had been repaying through equated monthly instalments (EMIs). His father and forefathers would never have approved of borrowing money and it was a principle he, too, held dear. But, he had been forced to take the loan when his wife insisted on moving into a house of their own, away from his parents.

Verma quickly calculated the balance amount that he had to repay the bank over the 5 years remaining. He had a chance to be debt-free if they clubbed the bonus and their savings.

Unhappy as she was at the prospect of letting go of the opportunity to buy her choice jewellery and clothes, his wife agreed to the idea. After all, the debt was forcing her to run on an austere budget every month in order to save enough for the EMI.

Verma himself had long craved for a swanky sedan of his own and she knew that. "May be we can prepay the home loan and then take the car," his wife suggested. But, the money just wasn't enough for both repaying the home loan and buying a car outright. "Well, let's take a car loan, then. We can prepay that with the next cheque."

That seemed reasonable enough to Verma. It gave him immense pride, too, to know that his wife was so good with money and also valued his principle of remaining debt-free!

But, was it really such a good idea to prepay the home loan and take a car loan? Perhaps not.

True, there would be no pre-payment penalty on the home loan as Verma's home loan carried a floating interest rate. (Had he taken a fixed rate loan, he would have had to pay a prepayment penalty of around 2% of the amount prepaid.)

But, the couple didn't realise that while the interest rate on home loan was in the 11-12% range, the rate on a car loan would be 12-15%. Hence, the decision amounted to paying back a cheaper loan and taking on a costlier one.

Thankfully, Verma decided to check with a friend who was a personal finance consultant and realised how wrong he could have gone.

Verma's friend suggested that he continue paying the home loan EMI for the balance years and buy the car from the bonus he has got. And if the car's price exceeded the bonus amount, he should make a higher downpayment and take a loan to cover the remaining amount.

That would limit the interest burden on the car loan and ensure that he remains debt-free at the end of five years, and the sole owner of both his house and car, too.