This article talks about the trade-off between prepaying your home loan and investing money elsewhere.
Buying a house requires a huge capital outlay. Most people find it difficult to purchase a property outrightly, and thus they finance their property purchase through borrowings. Homebuyers save money on rent by shifting into their own houses and there are various income tax benefits on the interest paid on home loans and principal repayment. Home loans are considered one of the cheapest loans and are extended for longer periods, usually 15-30 years. Generally, home loans are paid off through Equated Monthly Installments (EMI). The interest rate on home loans generally varies between 6.5-8% p.a. One who takes a home loan often faces a trade-off between prepayment of home loan and investment of surplus money elsewhere. As the tenure of a home loan is very long, borrowers may get or accumulate some lump sum money, or their regular income may rise substantially during this period. At this point, the borrower faces a dilemma between repayment of a home loan before maturity or deploying the money in some alternative investment products. The solution to this problem is customized for each person depending on factors like the mindset of the borrower, returns from other investments, tax benefits, and so on. The various factors that borrower should consider before concluding are:
Future Requirement of Money
The borrower must assess the money required in the future to meet other needs like education of children, the marriage of children, or some other financial commitment, before taking a decision to prepay his home loan. Home loans are the least expensive form of borrowing. Thus, if in near future, the borrower will need to take any loan to meet his other commitments the cost of borrowing such loan would be substantially high as compared to home loans. Thus, in such circumstances, it is advisable that the borrower do not prepay his home loan, and instead invest that money in short-term low-risk investment options, to use them as and when required for other purposes.
Home loans help taxpayers to save a good amount of tax. Following are some Sections of The Income Tax Act,1961 that provide tax benefits on home loans:
- Under Section 80C, tax deductions on the principal repayment are allowed up to Rs. 1.5 lakhs each financial year.
- Under Section 24(b), tax deductions on the interest amount payable of up to Rs. 2 lakhs on the self-occupied house and full interest on the let-out property each financial year.
- Under Section 80EE, additional home loan interest tax benefit for first-time homebuyers up to Rs. 50,000 each financial year.
Borrowers should evaluate the impact of making a prepayment on their tax liability before coming to any conclusion.
Alternative Investment Options
The borrower should follow a simple rule, if he thinks there are investment options that could generate after-tax returns greater than what he currently pays for home loans, he should avoid prepaying the loan and instead invest in such options. Since home loans have a long tenure of around 15-30 years, he should evaluate returns of alternative investments for an equal time horizon. While analyzing, borrowers should also consider the effects of tax saving and other cash flows embedded in both options.
Banks generally charge certain fees in case borrowers want to repay their loan before maturity. Whether prepayment fees will be charged or not depends on whether the loan taken is from banks or housing finance companies and whether it is under fixed-rate or floating rate. Housing Finance companies are not allowed to levy penalties on prepayment if another loan is not taken by the borrower to repay this loan. Few banks also have the policy to allow prepayment of loans up to a certain percentage without attracting a penalty. All these factors related to prepayment charges must be evaluated by the borrower before taking a final decision on the prepayment of the loan.
While taking a decision on whether to prepay home loans or invest the money elsewhere, we must evaluate all the factors mentioned above. Our decision should also take into consideration the present market conditions and the interest rates on our home loan. To simplify, let us assume home loan interest rates can be either greater than 7.5% or less than 7.5% and market conditions can be either bullish or bearish. Under these circumstances, our decision should be as follows:
|Home Loan Interest Rate||Market Condition||Our Decision|
|Less than 7.5%||Bullish||Invest your money instead of prepaying your home loan.|
|Less than 7.5%||Bearish||Prepay your home loan.|
|More than 7.5%||Bullish||Prepay your home loan.|
|More than 7.5%||Bearish||Prepay your home loan.|
We should also take into consideration tax effects before concluding as, if we prepay our loan, we will not be able to enjoy tax benefits on interest and principal repayments on home loans in the future.
Let’s understand this with help of an example: Rahul took a home loan of Rs. 30 lakhs at 7.5% p.a. The tenure of the loan was 15 years. Rahul accumulates Rs. 20 lakhs at the end of 5 years. Rahul has the option to either prepay his home loan (no prepayment charges) or to invest the money in mutual funds with projected earnings of around 10% p.a. Rahul falls in the 30% tax bracket. In this example, as we can see that if Rahul prepays his loan after 5 years, he will not have to incur any interest expense in the future, nor would he get any tax benefits. On the contrary, if Rahul invests his money in mutual funds, he will incur interest expenses, will get tax benefits on the home loan, and will also earn returns on mutual funds. So, in this particular example, Rahul should invest in mutual funds instead of prepaying his loan as benefits from investing outweighs his benefits in case of prepayment of the loan.