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. One needs to consider multiple factors before making the decision.
Effective interest outgo post tax: In the 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.
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.
Keep emergency funds: One should have enough money, to take care of the expenses of three to six months, in emergency fund for any contingency such as job loss or medical emergencies. Though prepaying the loan lowers your interest burden but if you don't have enough money in emergency fund, you may end up availing another costlier loan in case of an emergency. So, if you have a lump sum then it is better to create an emergency fund. You should plan to prepay only the surplus over and above this emergency fund.
Prepayment Improves CIBIL: 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," says Rachit Chawla, Founder and CEO, Finway Capital.
Investment for higher return: In case you have an investment option, which is yielding a higher return than the cost of your home loan, then it makes sense to invest rather than prepay the home loan. However, if you are looking to invest in fixed income products or debt investment then this option may not be very rewarding for you. If you invest in recurring deposits (RD) or fixed deposits (RD), which are currently fetching a return of around 7-8 per cent (the post tax return will come down further depending on the tax slab), it won't make sense to invest as the rate of interest on home loan is generally higher than the rate of interest on FDs and RDs.
However, equities have the potential to deliver double digit return over long-term. "One should only consider prepaying home loan if current investments or opportunity cost fetch a lower return than actual (after tax effect) interest burden. For example : If you earn an average return of 10 per cent/annum on your overall portfolio by investing into any asset class or financial instruments and you have to pay 6 per cent after tax effect cost of debt (loan), then why not? We will end up earning 4 per cent every year," says Abhinav Angirish, Founder, www.investonline.in. Therefore, if one has the risk appetite for equities, then one may consider the option of continuing with the ongoing EMIs and investing the regular surplus in equity mutual fund through monthly SIPs (Systematic Investment Plan). This will allow them to build bigger corpus than what they pay in their EMIs.
Even when you have a lump sum in the form of bonus, incentives, arrears and so on, investing in equity mutual funds in one go is not advisable. One can invest the bulk amount in a less volatile liquid fund and then opt systematically transfer of the money, on monthly basis to an equity mutual fund.
The decision to prepay or not will depend upon your individual situation and your risk appetite however, knowing all the options and their implication will help you in taking a well informed decision.