To borrow more or not?

You can unwind low-return investments and use them for, say, down payment of a house

Picture this. You have bank deposits that are earmarked to meet low-priority life goals or not earmarked at all. The interest rate on the deposits is less than the interest cost on home loan. Should you unwind these deposits to increase the down payment for your new house and reduce your borrowing cost? In this article, we discuss why unwinding a low-return investment to reduce borrowing cost is not just about spread analysis.

Beyond spreads

Rational individuals take decisions that save costs or increase income. But individuals are not always rational! Often, you let your emotions drive your decisions. Given this, how should you choose between unwinding a low-return-generating investment and borrowing at a higher cost?

Suppose you give up earning pre-tax interest of 6.75 per cent per annum if you unwind your bank deposit of, say, ₹30 lakh. But you can save 8.75 per cent of borrowing cost. Therefore, you can save ₹6,000, two percentage points (the spread) on ₹30 lakh every year. Of course, your savings would be higher for larger deposits and higher spread.

But before you unwind your deposit or other low-return-generating investments, consider an associated issue. It takes a while to accumulate large sums of money in an investment account. When you unwind an investment to make the down payment for a self-occupied house, you convert a return-generating investment into an illiquid and lumpy asset.

You may argue that living in a self-occupied house gives you emotional satisfaction. In addition, you save on rent.

If you had borrowed ₹30 lakh more from the bank, you would have loan repayments every month. However, you would have your bank deposits intact. Also, you would have increased your total wealth through your self-occupied house while managing your current living expenses within your monthly income after loan repayments.

Now, paying two percentage points on additional borrowings just to keep your fixed deposit seems costly, but not so if you consider the behavioural reason.

Suppose you have to pay ₹37,500 more because you decided to borrow additional ₹30 lakh from the bank. Instead, if you unwind your deposit, you not only wipe out your investment but also add ₹37,500 to your expenditure account! Why? This is because expenditure rises to meet income.

Systematic investments

There is, however, one way you can save on the spread and create investments. How?

The amount you save every month in borrowing cost, of ₹37,500, should be invested. The best way to do so is to set-up a systematic plan. That way, you will create wealth and not increase your monthly spending.

Your choice of investment should depend on your objectives. You can set-up SIPs in an equity mutual fund and a recurring bank deposit if you have a new life goal that you want to pursue. But if your objective is to simply re-create the fixed deposit that you unwound, you should set-up an RDrecurring deposit for the period of the home loan that you would have otherwise availed of.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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