When the equity markets are performing well and interest rates are low, and you have surplus money in hand, you may wonder whether you should go for investments or prepay a home loan you may have availed.
According to industry estimates, the average repayment tenure of home loans is around eight years, which means most borrowers prepay these loans.
It’s not surprising. When purchasing a home, the equated monthly instalment (EMI) forms a significant portion of the borrower’s payments. Most people stretch themselves when buying a property.
However, a few years later, after increments and job changes, the EMI as a percentage of the overall income reduces. Most borrowers then start prepaying their home loans with the surplus cash.
To decide on whether to prepay your home loan, you will need to evaluate your current situation and determine whether it makes sense for you to prepay or continue with the loan. As there’s no straightforward answer to the question, and experts’ views differ, you will have to take that call at your own discretion.
If you strictly look at numbers, there’s a thumb rule that suggests if you can generate better post-tax returns than the current interest rate on your home loan, don’t prepay. Instead, use that money to invest.
For example, home loans from banks at present could be at 7-7.5% rate. Most planners take 9-10% post-tax returns for equities over the long term. Going by the thumb rule, starting a systematic investment plan (SIP) for the long term works out to be a better option as the investment returns are about two percentage points higher than the home loan interest rate.
“No one can predict equity market returns. There is a possibility that current valuations in equities are stretched, and over the next few years, the returns may remain subdued. In such a case, the borrower may think that it was a better option to prepay than invest in equities,” said Arnav Pandya, founder of Moneyeduschool, an Ahmedabad-based financial literacy initiative.
Therefore, don’t go by the thumb rule alone.
Before you decide on prepaying your home loan, ensure that your basics are covered. You should have an emergency fund that covers 6-12 months of expenses. Also, there should be adequate life and health insurance cover.
“The individual should also check whether he or she is saving enough to achieve goals. If individuals are lagging in their goals, it’s better to step up the monthly investments first,” said Pandya.
A better strategy is to use profits from your investments to prepay your home loan rather than a bonus or extra money you have saved out of your income. “The individual can use a portion of the profits to prepay the home loan instead of using the capital. Whether individuals use 10% or 50% of the profits is entirely up to them. The idea is not to use the capital,” said Kartik Jhaveri, director, Transcend Consultants.
Some experts believe that an individual should not prepay if the tax benefits available on a home loan are a significant portion of the income, and there’s time to retire. A person gets up to ₹1.5 lakh tax benefit on the principal portion of the home loan and up to ₹2 lakh on the interest portion.
“If the tax saving is a significant portion of the income, it’s better not to prepay. The extra money in hand every year will give liquidity,” said Malhar Majumder, a Kolkata-based mutual fund distributor and partner, Positive Vibes.
He added, “It would make sense only to prepay when close to retirement and the person wants to finish all the liabilities.”
Also, before you make a decision, do evaluate if you have any significant expenses some months later.
According to financial planners, people often prepay their loans with extra cash and later take a loan or swipe a credit card to meet a considerable expense a few months later.
Evaluate your situation first, then decide on whether you should prepay or invest the surplus cash.
Source : Live Mint