Case 049Client portfolios and goal planningWarm up
A client has Rs 3 lakh of surplus. Her home loan costs 9.2% and an equity fund might earn 11% with volatility. Where does the next rupee go: prepay the loan or add to her SIP?
1The situation
Divya Rangan, 34, a software engineer, has received a Rs 3 lakh bonus. She already keeps six months of expenses in a liquid fund and runs a Rs 25,000 monthly SIP in an equity fund from her salary. Her home loan has Rs 32 lakh outstanding at a floating 9.2%, with 16 years left, and her bank allows prepayment without a charge.
Her adviser assumes, for planning only, that equity funds return about 11% a year over the long run with volatility of about 18% a year. She asks where the Rs 3 lakh should go: prepay the loan, or add a lump sum to her equity fund.
2Your task
Compare the two uses of the next rupee over five years and over the life of the loan, and say where the Rs 3 lakh should go and what would change the answer.
Quick check
Over five years, how often does the equity route end up ahead of prepaying, on these assumptions?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Prepay the loan with the bonus: a certain 9.2% saving is within two points of an uncertain 11%, and over five years equity beats it only about 58% of the time. Her emergency fund and SIP are already in place, so the bonus can take the sure return. The answer flips if her loan rate falls below about 8%, if she claims a tax deduction on the interest that lowers its cost, or if her emergency fund were thin.
Step 1What does prepaying actually earn?
Paying off a 9.2% loan early is like finding an investment that pays exactly 9.2%, every year, with no chance of a bad year. Prepaying a loan earns its interest rate with certainty, so it should be compared with an investment's return after its risk, not with its headline expectation. Rs 3 lakh prepaid saves interest that would have compounded at 9.2%; after five years that is worth Rs 4.66 lakh in loan she no longer owes.
Step 2How does the equity route compare over five years?
On the adviser's assumptions, Rs 3 lakh in equity has a median outcome of about Rs 5.06 lakh after five years, more than prepaying. But the range is wide. One time in ten it ends below about Rs 3.02 lakh, barely what she put in, and overall it ends ahead of the prepayment only about 58% of the time. Over the 15-plus years left on the loan the odds improve to about 64%, because time narrows the spread of yearly returns relative to the edge.
Step 3So where does the next rupee go, and what would change it?
Check the order of priorities first: emergency money, then high-cost debt, then investing. Divya has her emergency fund and an SIP already running from salary, so she is not choosing between saving and not saving; she is choosing the home for one lump sum. With the loan at 9.2% and equity's expected edge under two points, the certain return wins for the bonus, while the SIP keeps her long-term equity exposure building. Prepay to shorten the tenure rather than cut the EMI, so the saving compounds.
Three facts would change the answer. If she uses a tax regime that lets her deduct home loan interest, the loan's after-tax cost is lower than 9.2% and equity looks better; confirm her regime and the current rules. If her bank cuts the floating rate below about 8%, the case for prepaying weakens. And if her emergency fund were thin, the bonus should top it up first, because a prepaid rupee cannot be borrowed back easily. Equity's 11% and 18% are planning assumptions, not forecasts.
Where candidates lose it
The common loss is comparing 11% with 9.2% and choosing equity because the number is bigger. That compares an uncertain expectation with a certain saving; the right comparison asks how often equity actually wins.
The second miss is ignoring liquidity. Money sent to the loan is hard to get back, so the answer depends on her emergency fund being in place, which is why the interviewer gave you that fact.
What the interviewer asks next
- Her loan rate falls to 8.1%. Does your answer change?
- She is 50 with 4 years left on the loan. What then?
- How would you explain the probability of equity winning to a client in one sentence?
Asked at Invesco, Real Estate, Dallas, 2023 (Wall Street Oasis): If you had a $1 today, what would you invest it in?
Company names and figures are illustrative.