Many home loan buyer face the dilemma whether to prepay their home loan or invest the amount to get better returns? Here, we need to look not only the return part on investment but also the psychological front of a person. Here, i will discuss some the factors which may help you to decide what to do.
If your annual interest outgo is higher than Rs 2 lakh, it makes sense to prepay the loan partially, and save on future interest payment. You can, however, optimize the tax benefits if the loan has been taken jointly, say, with your spouse. If joint holders share the EMIs, both can claim Rs 2 lakh each in interest deduction. For more details, read Home Loan Tax Benefits.
Lenders generally charge some prepayment charges for you prepaying any home loans. The quantum of such charges is dependent on the agreement executed by you with the lender. Such charges normally vary between 1% to 4%. Some of the lenders even do not charge you any prepayment penalty. This applies whether you have taken loan under floating or fixed rate of interest. RBI has also advised all the banks not to levy any prepayment penalty on all the loans taken under floating rates. So in case you have taken home loan under fixed rates, the banks can still charge you prepayment penalty even if you prepay the home loan from your own resources.
Lending institutions normally do not charge any prepayment penalty if the amount prepaid does not exceed 25% of the loan outstanding at the beginning of the year. So in case you are prepaying partly within the limit of 25% you can do so without having to pay any penalty.
As a thumb rule, you should go for investment, instead of prepayment, only when the post-tax return from the investment is likely to be higher than the effective cost of the housing loan.
Certain special loan products allow overdraft facilities to help the borrowers maintain liquidity. They may park the surplus funds in these products without considering prepayment. This option allows them to prepay the outstanding loan; however, if they need the funds in the future, they are able to withdraw this money.
As of now we are seeing a decrease in home loan rates and an upward trending equity market. You shouldn't prepay your home loan and must continue your SIP. We support home loan as it is a good loan with an asset backing, you also save on rent if it is the home that you live in. The rationale is that it's a long-term loan and you pay a reasonably low rate of interest along with the advantage of a tax break. The additional money that you have which you want to prepay should be invested in long-term equity mutual funds. The returns will be far superior to what you would have otherwise saved by prepaying your loan.
In home loan, interest on loan is recovered before recovery of principal amount. As years progress , interest component decreases and principal component rises. So, it is better to prepay in early stages of home loan.
Psychological Front
First variable to consider is how much comfortable are you with loan on your head. Will debt free make you happy? Some people want to pay their home loan at earliest to reduce stress. You should be wary of unfortunate happenings— job loss, death of the earning member, serious illness, etc—can cause trouble during the 10-15 year loan period. Treat it as a mind game and not a numbers game and prepay your home loan first.
Home Loan Interest Rate
If you have already passed above point than you are hoping to get better returns instead of prepaying the loan. With the declining home loan interest rate, it is advisable to look for alternative investment methods to get better returns. Before making any alternative investments either in mutual funds, stocks etc, you should also consider below points -- How far is your retirement? If it is near than you should prepay your home loan as you may not have active source of income after retirement.
- Do you have enough emergency fund? Emergency fund is your contingency fund and you should have enough fund to deal with medical emergencies and job loss. If you don't have emergency fund than you should start accumulating for emergency fund rather than prepaying or investing.
- Do you need some money in the coming years? If you need money in coming years than you may not consider to prepay your home loan. As once you prepay the loan amount you cannot withdraw it back. Although there are special loan accounts that allow prepayment with option of withdrawing money.
- Job security and risk profile? Do you have a stable job? Are you willing to take extra risk to get those extra returns? These are the questions you need to ask yourself. If your answer is "No", then prepay home loan.
Home Loan Tax Benefits
Home loan principal and interest payment is exempt from income tax with below listed limits.- Section 80C: Principal payment, Stamp duty and registration fee payment upto Rs 1,50,000 qualifies for tax deduction.
- Section 24C: Interest payment up to Rs 2,00,000 qualifies for tax deduction. This limit is for both self-occupied and let-out property.
If your annual interest outgo is higher than Rs 2 lakh, it makes sense to prepay the loan partially, and save on future interest payment. You can, however, optimize the tax benefits if the loan has been taken jointly, say, with your spouse. If joint holders share the EMIs, both can claim Rs 2 lakh each in interest deduction. For more details, read Home Loan Tax Benefits.
Cost of prepaying
Lenders generally charge some prepayment charges for you prepaying any home loans. The quantum of such charges is dependent on the agreement executed by you with the lender. Such charges normally vary between 1% to 4%. Some of the lenders even do not charge you any prepayment penalty. This applies whether you have taken loan under floating or fixed rate of interest. RBI has also advised all the banks not to levy any prepayment penalty on all the loans taken under floating rates. So in case you have taken home loan under fixed rates, the banks can still charge you prepayment penalty even if you prepay the home loan from your own resources.Lending institutions normally do not charge any prepayment penalty if the amount prepaid does not exceed 25% of the loan outstanding at the beginning of the year. So in case you are prepaying partly within the limit of 25% you can do so without having to pay any penalty.
Return expected from alternative investment avenues
Investment instruments like direct equity and equity mutual can give you better returns, then interest paid on home loan. Long term investment in equity, can fetch you returns in the range of 10-15%. If you find such equity instruments are risky or returns from your investment post tax are less then your effective home loan interest rate, better prepay your home loan.As a thumb rule, you should go for investment, instead of prepayment, only when the post-tax return from the investment is likely to be higher than the effective cost of the housing loan.
Certain special loan products allow overdraft facilities to help the borrowers maintain liquidity. They may park the surplus funds in these products without considering prepayment. This option allows them to prepay the outstanding loan; however, if they need the funds in the future, they are able to withdraw this money.
Conclusion
Mostly it is individual's choice. If you are not comfortable with any loan on your head than prepay the loan first and start investing later. Peace of mind is more important than any mathematical calculation.As of now we are seeing a decrease in home loan rates and an upward trending equity market. You shouldn't prepay your home loan and must continue your SIP. We support home loan as it is a good loan with an asset backing, you also save on rent if it is the home that you live in. The rationale is that it's a long-term loan and you pay a reasonably low rate of interest along with the advantage of a tax break. The additional money that you have which you want to prepay should be invested in long-term equity mutual funds. The returns will be far superior to what you would have otherwise saved by prepaying your loan.
In home loan, interest on loan is recovered before recovery of principal amount. As years progress , interest component decreases and principal component rises. So, it is better to prepay in early stages of home loan.
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