How does a loan work and how to repay loans faster?

Large part of our monthly income goes into repaying our debt. Debts can affect us in multiple ways. It can take a toll on our mental health as well. The constant mind nagging all the time to be able to pay the next EMI can be very disturbing. Debts won’t let you be free and happy especially when a large chunk of your income goes in to paying your EMIs. Having the stress to be able to be repaying your debt for a long time makes it all the more difficult to budget, save or invest. You may be very eager to start investing but the benefits of repaying first may out weigh investing. Having your income freed up can not only improve your budget but also boost your morale.

How to close debts faster?

Friend and I on our way back home from a party, we were discussing about the loans that we had taken a few years ago for our education. He had taken a loan of 2.8L for his engineering. He knew that he could start paying back his loan after 4 years plus one year (moratorium period) or as and when he gets a job. He started paying the EMI right from his first salary. After doing so for a couple of years while he was expecting a good chunk of his loan to be already paid, he got a shocker news. He still had to pay huge amount of the loan.

I have been on this boat too. Even after repaying for several years if you check your loan statement, it will show major portion of your loan yet to be paid off. If you are paying an EMI, I strongly suggest you to go to bank and ask for the loan statement. Chances are if you are paying the EMI amount that the bank had told you, you are in soup.

This has everything to do with the structure of how these loans are designed. They are built to get maximum possible interest from you. Afterall, this itself is their roji rotti (or income). In the beginning, a larger chunk of your EMI goes into the interest and not the principle amount.

Let us say you decided to take a loan of 10L at 9% interest rate. You ask him what the tenure and the EMI cost will be and to which he replies you can pay Rs. 12.5k every month for next 120 months. You are extremely happy. You feel the amount isn’t that high and you may not even feel the pain when 12.5k gets deducted from your salary. You agree to it, and you ensure that you pay the EMI every month without fail.

Two years down the line you feel you have made a significant amount of repayment (i.e 3L) and with interest you feel the outstanding amount should be well below 10L. You go to the bank and ask the manager how much of the loan is outstanding, you would be shocked to hear from him that you would still have to pay close to 9L. You ask him how would that be possible?

Well the calculation is simple. In the first month when you paid 12.5k, only 5k went towards the principle and 7,500 went towards the interest. This is the amount of interest on the 10L you borrowed. This happens to all the subsequent months. After 2 years, you would’ve actually paid only 1L towards the principle and 2L towards the interest. This is the reason why we feel as if loan repayment is never ending. By the end of 10 years you would’ve paid a total of over 15L. You would've paid over 5 Lakhs just in interest.

Now assume you had the potential to pay 25K every month. This same loan would be closed in 48 months or 4 years and the total interest amount would be close to 1.9L.

By just doubling your monthly EMI, you can actually reduce the tenure and interest amount by about 60%.

I understand it is difficult to pay twice the EMI for most of us, but we can at least push as much as possible and pay higher EMI every month. Even if you increase the EMI amount by 2.5k a month, you can reduce your interest amount by 1L and tenure by 15 months.

Another thing that you can and must do is to increase the EMI every year. If you get a hike of 8%, you can consider increasing your EMI by at least 5%. Combining this strategy with 2.5k extra every month, you can reduce total interest by 1.5L and close the loan by 7.5 years.

Typically there are multiple ways to repay your loan faster. You can increase the EMI or reduce the tenure, you can pay a lumpsum amount as and when you get your variable bonus or annual bonus or you can increase the EMI every year. You have to do everything in your power to close your debts at the earliest especially if it is a high ticket loan spanning 25 years such as home loan. In such cases target should be to close by 10 years.

How to get rid of multiple Debts

There are two ways to get out of debts – Snowball method and Avalanche method.

Snowball method – If you have a lot of loans in your name and it is difficult to manage them all, this method could be the better option of the two especially if you find it difficult to track your debts.

With this approach you tackle the smallest loan first, pay it off and move to the next smallest loan. You put most of your money into the smallest loan and just pay the minimum payment for all the other loans irrespective of the interest rate. What this does is takes out one loan after the other. This way you reduce the number of debts, free up some money and tackle the next loan more aggressively. The advantage of this method is that it builds motivation and keeps you going. However it will be the expensive option of the two.

Avalanche method is to pay maximum amount towards the loan that has highest interest rate and just the minimum amount for rest of the loans. This is a practical way to pay off your debts. This will save you on interest payments. Unless you have too many number of debts to handle or needs constant motivation to keep paying the EMIs month after month, this approach could be a better choice.

Now, there is another type of debt which you may be thinking of not paying sooner. The Home Loans or the Education Loans. The ones that help you in tax deductions. Before taking this call to pay these loans slower in order to take advantage of tax deductions, you may want to do a cost benefit analysis. You may be actually paying more in interest than you would pay in tax. Repaying loans where interests paid would be higher than tax to be paid would be a wiser choice.

Interest paid on home or education loans could be greater than the tax you save. You are better off reapying the loan faster.

*You can ignore the below calculations if you go bonkers with numbers and calculations :D

Assume you performed really well at your work and your boss was very impressed with it. She decides to give you an annual bonus of 1 Lakh. You are very happy and you are thinking of putting all the money into your home loan (or education loan) so that the outstanding principle reduces. You discuss this with your friend and your friend suggests otherwise. He says your loan is tax deductible and by repaying your loan faster you would end up paying higher tax. You give it a thought.

Let’s say your loan interest rate is 7% and you fall under the 10% category. Your outstanding principle is somewhere around 10 Lakhs. That means you would have to pay 70,000 in interest this year (real life calculation is much more complicated. Let us simplify these calculations for better understanding). You get tax savings of 7,000 when you do not ustilse 1 Lakh. However, if in case you deciede to put 1 Lakh and reduce your principle to 9 Lakhs, your interest would be 63,000. Tax saved would be 6,300. Hence, in order to save 700 extra in tax, you would end up paying 7,000 in interest.

Hence, by paying 1 Lakh early, you would have potentially paid 700 extra in tax while you would have saved 7,000 in interest payment. We will look at tax calculations in later chapter but for now you can try to see why in most cases reducing your interest outflow could be more beneficial than saving in taxes.

Note: Above calculations are over simplified for understanding purpose. Actual numbers are much higher and considerably complicated to understand.

Now this begs another question. Mutual funds can give me better returns. Why don’t I invest instead of repaying my debt? More on this later.