Laddering of loans can help you be debt-free

Loans give you the ability to live tomorrow's lifestyle today. In my father's generation, people would save for years to buy an asset such as a car or a house. Today, because of readily available loans, you can buy an expensive asset such as a house, jewellery or vehicle within a few years of starting off your career. 

For most people, home is one of the biggest assets in their portfolio. There is no harm in availing a loan, provided the EMI you pay over the year forms less than 50% of your annual income, you have job security and you can finance the loan comfortably. However, for most people, loan becomes a psychological burden until it is cleared. Does it make sense to use existing assets to reduce or close a loan or should you continue a loan to tenure? You should decide on continuing or closing your loans based on interest rate, outstanding loan and tax benefits. 

Let's say your outstanding home loan is Rs50 lakh, at an ongoing interest rate of 10%. You are on the verge of receiving a bonus of Rs10 lakh and are trying to decide where you can deploy this money. Your options are: a) Invest in a long-term equity investment, which can grow at an annualised rate of 12-15%. b) Invest in a safe debt investment, which grows at an annualised rate of about 7%. c) Reduce your home loan. d) Close out your outstanding car loan of Rs3 lakh, on which you pay 12% interest. e) Pay down an overdue credit card loan for Rs1.5 lakh, running at an interest rate of 33%. f) Fund a long-cherished foreign holiday, which will cost you nearly Rs8 lakh.

Here is how you should ladder your deployments: a) Pay your credit card loan first. b) Then your car loan. c) Use the balance to reduce home loan. d) Use bonuses to invest in equity or debt, in line with your asset allocation. e) Fund the holiday after clearing out these obligations.

You should knock off the credit card loan first as it carries the maximum interest rate. It is almost impossible to get a guaranteed, tax-free, 33% annualised return on any investment. By closing the credit card loan, you are saving yourself the punitively high-interest cost, besides preventing your credit score from declining further. 

Second is closing your car loan. Your car is a depreciating asset, and its value falls the minute you drive it out of a showroom. In some cases, corporates offer car leasing schemes, where repayments offer tax benefits. Business owners can expense the payment and receive some tax breaks. For most others, car loans give no tax benefits. Car loans typically come at higher interest rates than home loans. While property has the potential for capital gain or income generation, a car has neither. It is simply an expense you incur each month till you clear the loan. 

The third would be to chip away at the home loan so that you pay no more than Rs2 lakh in interest cost in a year. The government gives us the biggest tax break on home loans. Rs1.5 lakh of principal repaid is deductible under Section 80C and Rs2 lakh of interest cost is deductible under Section 24 on self-occupied properties. Any interest cost above Rs2 lakh delivers no tax benefit. Unless you are in a low tax bracket, you will do well to bring down your home loan to minimise your interest cost.

Next would be your investment in equity/debt or other assets based on your required asset allocation. The last would be the holiday expense. This is, of course, a matter of personal choice. You may choose a holiday over investment if you're on track with your investment goals for the year. However, if you are deciding between bringing down your home loan and investing in equity or debt, keep in mind that almost no investment today can guarantee you a risk-free-tax-free annualised return of 9-11%, which is roughly the interest cost on your home loan.

There is no harm in taking a loan. Just make sure the loan is not so large that servicing it becomes strenuous. You must have assets to pay off the loan in an emergency, hence your net worth must always remain positive. The EMI must be such that it leaves enough of a surplus for you to invest in other assets for the short or long term. 

Don't take unnecessary loans such as personal or credit card loans, loans to invest/speculate in the market or loans to pay off other loans. Remember that the repayment of loans depends on future income. If that income stream gets jeopardised for whatever reason, you may fall into a debt spiral that you can't climb out of. Last but most important, pay down all loans before you retire. You do not want a rigid commitment towards an expense when the income stream may be inflexible.