Musings by Dr Aarti

http://money.outlookindia.com/article.aspx?87530

Should borrowing be only a last-resort option to raise money?


AMONG THE many questions that clients raise with a tax consultant, one of the most common is: "I need funds for such and such purpose. Given the fact that loans are available, should I borrow or would it be better to encash my investments and raise the money?" Tough decision on the face of it, but one that can easily be taken if one carefully assesses various qualitative and quantitative factors.
Among the qualitative factors, one would look at liquidity, the possibility of reinstating the investment out of future income, restrictive conditions attached to the borrowing and such like. But, of course, the crucial deciding factor will be the quantitative aspect, that is, the loss of post-tax returns from the investment and the post-tax cost of borrowing.


If the post-tax cost of borrowing is higher than the loss of post-tax returns from the investment, it’s better to disinvest your holdings, rather than borrow. If, on the other hand, the post-tax returns from the investment are higher than the post-tax cost of borrowing, it’s a better option to take a loan, than encash your investments.

Post-tax edge. So how does one compute the post-tax rate of returns and post-tax cost of borrowing? In computing the post-tax rate of returns or the cost of borrowing, one has to first compute the annualised rate of return or the cost of borrowing, and then adjust it for tax payments or savings.

To understand this better, let us consider a simple computation in a situation where an individual wants to buy a residential house for Rs 15 lakh. Let’s say he has Rs 5 lakh in hand, Public Provident Fund (PPF) investments that he can withdraw to the extent of Rs 10 lakh and company deposits of Rs 10 lakh that yield 11 per cent per annum compounded quarterly.

So, he has three options.
Option I: he can withdraw Rs 10 lakh from his PPF account.
Option II: he can break his company deposits, but in doing so, he will incur a penalty of 1 percentage point for premature encashment.
And Option III: he can take a home loan from a housing finance company at the rate of 11.5 per cent per annum (payable in equated monthly instalments with monthly reductions in the principal amount).

In the last case, he will have to pay a processing fee of 2 per cent of the amount of the loan.

Option I. In the case of the Public Provident Fund, after the recent reduction in interest rates on small savings, it will yield a return of 9 per cent per annum. Since this interest is paid annually, and there is no charge for withdrawals, the effective rate of return is equal to the coupon rate. Besides, since this interest payment is not taxable, this will be the post-tax rate of return as well.

Option II. At a rate of 11 per cent per annum compounded quarterly (2.75 per cent per quarter), the effective yield is 11.46 per cent. Since we are computing the loss of post-tax interest that arises due to disinvestment, we will also have to factor in the penalty for premature encashment.

The real rate of interest that has been lost due to premature encashment will, therefore, have to be computed by deducting the percentage of the penalty from 100, and dividing the annualised rate of return by this figure. In this case, by dividing 11.46 by 99 (100-1), the adjusted annualised rate of interest will be 11.58 per cent. Since this interest would have been taxable, and as the premature payment penalty would also be tax-deductible, this rate of interest will have to be discounted by 31.5 per cent (30 per cent plus surcharge of 5 per cent, which is the marginal tax rate applicable to the house buyer). Thus, the post-tax loss of interest would be 7.93 per cent.

Option III. In the case of the home loan, by compounding the monthly interest payable, the annualised rate of interest works out to 12.13 per cent. If we factor in the processing charge, we can deduct the charge of 2 per cent from the total loan amount (that, 100 per cent) to arrive at a net borrowing of 98 per cent. The adjusted annualised rate of interest thus works out to 12.37 per cent.

Since interest paid on housing loans is tax-deductible, this payment needs to be discounted by 31.5 per cent, giving us a cost of 8.48 per cent. The rebate available on the repayment of the principal amount of the housing loan will also need to be factored in. Since the rebate is available at the rate of 20 per cent to the extent of repayments of Rs 20,000 each year, and the rebate is to be computed before surcharge, the effective tax saving would be Rs 4,200 each year. On an average outstanding loan of Rs 5 lakh, the effective percentage of rebate works out to about 0.84 per cent. Thus, the post-tax cost of the housing loan from the finance company will be about 7.64 per cent (8.48 per cent minus 0.84 per cent).

What’s beneficial? Comparing the options we find that the post-tax cost of the loan is lower than the post-tax loss of interest in the case of the company deposits or PPF. And so, an individual will be better off taking a home loan to buy a house, rather than encashing either the PPF or the company deposits. If, however, the individual does opt to encash some investments, the company deposits are a better option than the PPF, since the loss of interest is of a lesser magnitude.

In the case that we have taken up, since the loan was being taken to buy a residential house, the interest was tax-deductible. Therefore, before you take a loan it makes sense to take a look at how you are going to utilise the borrowing and whether the interest is deductible for tax purposes. There may be many instances where interest will not be deductible for tax purposes. In such cases, the effective cost of the borrowing is generally far more than the rate of return that one could earn on most investments, and borrowings may, therefore, not be cost-effective.

The computation in the case we have looked at assumes that the eligible deductions on interest repayments and rebates on principal will continue to be available, and that the rates of interest will remain unchanged. In real-life situations, you will need to consider the prevailing tax laws and rates of interest to arrive at your best-case scenarios.

Of course, one can always use other similar methods of computation to compare the merits of various investments. Although other methods such as internal rate of return or net present value of cash flows are often superior decision-making tools, this method offers a simple and quick comparison for a person who is not a finance professional.