With inflation ruling at a 13-year high, not only has one’s daily expenses increased but the value of savings and investments has also got eroded to a large extent. This makes the going tough for people with fixed or salaried income.

Moreover, the Reserve Bank of India increased key lending rates to banks in quick successions between April and June this year to squeeze money supply and suck excess liquidity out of the system. These monetary tightening measures are bound to be followed by another round of rate hikes by banks on personal and home loans .

Loan some

With lending rates going up, prospective borrowers of home and car loans may shelve their plans till the interest rates cool down. But those who had taken a loan three years back when interest rates were low will now find that half of their net income is going towards paying increasing EMIs.

Though one can claim a deduction under section 24 of the income tax act for paying higher interests on home loans, the tax benefit will be accrued only at the end of the financial year. Till then one will have to shell out from one’s current disposable income to pay for higher EMIs along with soaring household expenditures.

Let us examine how savings and investments are getting affected by the sustained increase in prices of essential commodities and interest rates.

Negative returns

Small-saving deposits such as Public Provident Fund (PPF), National Savings Certificate, and Post Office Monthly Income Schemes are giving an annual interest rate of 8 per cent, while the rate of inflation is hovering above 11 per cent. The Senior Citizen Savings Scheme yields a 9 per cent return.

Banks have recently increased their rates for fixed deposits for more than three years to 9-9.5 per cent. However, this is still 1.5 to 2 percentage points below the inflation rate. Deposit rates in banks are unlikely to go up from the 9-9.5 per cent levels in the near future because banks have raised these rates recently.

Fixed-income instruments are thus yielding a negative inflation-adjusted return.

It may be argued that since these are long-term deposits, generally made for three to six years, occasional inflation spikes won’t affect the returns value over the entire term of the deposit.

While it is true that the average annual rate of inflation over a period of five to six years won’t be more than 5-6 per cent, leaving a 2-3 per cent real return from such deposits, one must also remember that one may not be able to save much in the case of a high loan liability.

Repay in advance

Higher payments towards EMIs eat into an individual’s disposable income.

Moreover, for people taking a long-term loan, such as a housing loan, the loan amount is usually higher than one’s savings in fixed-income assets. Thus, it makes sense to withdraw the term deposits in small savings schemes and banks foregoing an annual interest income between 8 and 9 per cent and prepay the loan that may otherwise have to be paid at an annual interest rate of 10-12 per cent. Many banks and financial institutions allow part prepayment of loans without any penalty if it is made from an individual’s past savings or windfall gains.

A prepayment of a loan, however, makes sense if one is halfway through one’s loan tenure. This is so because the interest component is much higher than the principal repayment during the initial years.

Let us illustrate this with an example. Raja and Rahul each took a home loan of Rs 10 lakh at the same interest rate of 8 per cent three years ago. Raja took the loan for a period of five years, while Rahul took it for 15 years. Raja pays an EMI of Rs 20,276, while Rahul pays Rs 9,556. After three years, Raja’s principal loan outstanding is Rs 4,48,322 and that of Rahul’s is Rs 8,82,858.

Now suppose the banks have increased their lending rates to 9 per cent. Raja’s new EMI will be Rs 20,481 and Rahul’s will be Rs 10,047. Both of them decide to prepay Rs 1 lakh each from their savings towards their loan outstandings.

After the prepayment, Raja’s EMI at 9 per cent interest rate will be Rs 15,913 if he has to repay the loan in the remaining two years. Thus Raja can save Rs 4,363 every month towards the EMI outgo or a total of Rs 1,04,712 towards interest outgo in the remaining two years. If Raja wants to pay the initial EMI of Rs 20,276, he will fully repay his loan outstanding in 18 months, six months before the scheduled time.

Rahul’s EMI after prepaying Rs 1 lakh will be Rs 8,909, or a saving of Rs 647 per month. His total savings in interest outgo during the remaining 144 months is Rs 93,168. If Rahul continues to pay his original EMI of Rs 9,556, he will repay the entire loan in 134 months, 10 months before the actual schedule.

It is thus clear that Raja gains more than Rahul by prepaying the loan. The same rule can be followed in repaying one’s credit card outstanding and other loans.

Expenditure budgeting is crucial in beating the inflation blues. In fact, investment planning and expenditure budgeting go hand in hand in the entire exercise of financial planning, particularly at the time of high inflation.