Home Loan Prepayment Vs Investment

Home Loan Prepayment Vs Investment

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Should I pay off my home loan or continue investing in the hope of decent returns? This is the most intriguing question which keeps playing on the mind of a large number of home loan takers, particularly in a falling interest rate regime like the current one. After all, when returns on investment avenues are not guaranteed or the current yields are all set to fall further, then doesn’t prepaying high-interest or longer-duration loans like a personal loan or a home loan seem to be a better option? However, is doing that a wise proposition?

As opposed to the previous generation that used to save for years to buy their home, the current generation prefers possession of a house very early in their life, which has been made possible due to easy accessibility of home loans. A home loan is generally the biggest financial debt most people take in their lifetime. At the time of availing a loan, most people stretch their borrowing limit to get a better home and hence are left with the only option to be able to service the EMI.

However, with time as their income grows they are confronted with the question whether to make partial prepayment or to invest the surplus. As conventional wisdom says, it is always better to get rid of any kind of debt, as it not only saves the interest cost but also provides the sense of financial freedom. But home loan comes at the lowest interest rate and offers significant tax saving opportunity as well. So the answer to the question is not straightforward.

Investing money or prepaying loan/loans depends on the choice of investors. There is no denying the fact that currently home loan interest rates are the lowest in a very long time. This has its own advantages. For instance, when rates fall, you get the ideal opportunity to make pre-payments, because, at a lower rate, your pre-payments will have a higher impact on reducing your long-term interest.

The following are the factors one need to check before making the decision:

1. Effective interest outgo post Tax

In case of a home loan, the income tax law allows a deduction of up to Rs 1.5 lakh on principal repayment under Section 80C and Rs 2 lakh on the interest paid during the financial year under Section 24. Therefore, when one considers this, the effective interest rate on home loan reduces.

For example: For a home loan of Rs 30 lakh for a tenure of 20 years with an interest rate of 8.5 per cent, the cost of interest for the first year comes out to be Rs 2.52 lakh. The deduction of Rs 2 lakh will result into a tax saving of Rs 60,000 for a person in the highest tax bracket of 30 per cent. Therefore, effective rate of interest will come down to around 6.42 per cent. Even people falling in 20 per cent and 10 per cent tax bracket can save good amount of tax of around Rs 40,000 and Rs 20,000 per year, respectively. The effective tax rate for a person in the lowest tax bracket (20 per cent tax slab) will be 7.09 per cent and second slab will be (10 per cent) 7.76 per cent. So, before making partial prepayment one should also consider the actual interest outgo.

2. Optimise the interest outgo after Tax Deduction

The maximum deduction one can avail on the interest portion is Rs 2 lakh. If you have bigger home loan, which is more than Rs 40 lakh, then you would be paying much higher interest amount each year than what you can utilise for tax saving. In such a case, a partial prepayment would make more sense for you to bring down your home loan outstanding, to a level at which you can utilise maximum tax benefit and significantly reduce effective cost of your home loan. Typically, if a loan is in the range of Rs 25-35 lakh, the interest amount remains in close range of Rs 2 lakh at least for half of the tenure. This allows you to maximise your tax benefit for good number of years. Therefore with your surplus money, you can go for partial prepayments, to bring down your loan outstanding in the range of Rs 25-35 lakh at current interest rate scenario.

3. Investment Returns

Now you need to decide where you would like to invest your money with an assumption that option to prepay loan is ruled out. Key considerations should be Return on Investment, Tax treatment of returns, Risk etc. Assuming, you are planning to invest in FD and ROI is 8.5%. Depending on the tax slab, let say my post tax return is 6.9%. In another scenario, if you are planning to invest in equity with an expected returns of 15%. The risk will be high in equity compared to FD. Depending on your risk appetite, investment amount and other factors you can finalize the investment option & corresponding return projection.

4. Fund Requirement

Before making any decision to prepay loan or investment, you also need to check any short to medium term fund requirement. Reason being, in case you decide to prepay loan then this amount is completely illiquid i.e. you cannot get funds back. In one of the cases, i observed that borrower made a huge prepayment of 10 lacs but has not considered near future fund requirement for some personal expenses. The same borrower then applied for the personal loan to meet his requirement. It is a highly undesirable scenario. In this case, the option to prepay loan should be ruled out without a 2nd thought. Let’s assume that if you decide to prepay loan then your contingency fund and other insurance requirements are taken care of.

5. Prepayment Advantages

Apart from reducing the mental stress, there are other benefits of making partial prepayment of loan. Advance home loan payments tend to improve a person’s CIBIL profile, thereby making him eligible for more profitable financial transactions, deals and borrowing.

How to Decide?

It is very simple. You just compare the net interest rate of the loan and net post-tax return from an investment. If you can generate returns more than the net interest rate of the loan then it is a wise decision to invest the money else you may go ahead to prepay loan. For example, if i can generate the net post-tax return of 12% but my personal loan interest rate is 14% then it will be a wise decision to prepay loan. Another way round if my net home loan interest rate is 8% and return on investment is 12% then it will be financially wise decision to invest the money.

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