Should you prepay a home loan before you retire?

Manoj Pradhan, who is set to retire in five years, has two properties. Since he has taken a home loan, one of these is mortgaged with the bank. He gets a concessional rate as he is a bank employee and hasn’t prepaid the loan. He is banking on his pension, rent and investment returns for post-retirement needs. He isn’t sure if he should repay the loan before he retires or allow it to continue. He needs help in taking the decision.

If there is an unpaid loan at the time of retirement, there are financial as well as emotional considerations. The financial logic is simple. If the money used to repay the loan can earn a higher return than the cost of the loan, it is a good idea to let it grow rather than use it for the loan. By reverse logic, it makes no sense in keeping the money in a 9 per cent deposit when a loan, taken at, say, 11 per cent, needs to be repaid. If the value of the house is growing at a rate higher than that of the loan, retain the loan.

On the other hand, there is emotional comfort in not having a loan or liability. Having a loan means that any risk to income in the future can reduce the ability to repay. For the sake of this emotional freedom, many people ignore the financial logic and prefer to prepay their loans.

Since Pradhan is close to retirement, he anticipates a lower income in the future and may not want the risk of having a loan. The final decision that Pradhan takes depends on how he sees this trade-off. If he earns a rental income from his house and uses it to repay the loan, the risk for income may be lower. On the other hand, using retirement corpus or investments for the loan might reduce the funds meant to generate post-retirement income.

If Pradhan compares the investment return and loan rate, he may find that the former is higher than his concessional interest cost. So, he should keep the loan unless his emotional need to repay is greater.

(Courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre and Arti Bhargava)