BORROWING
Prepay Your Home Loan or Invest the Money?
Every rupee you put towards a home loan earns exactly the loan's interest rate, with no risk. Investing can earn more. The decision comes down to whether the extra return is worth the uncertainty.
What prepaying earns
A prepayment goes straight to the principal. Interest is charged on the principal every month, so from then on you pay interest on a smaller balance for as long as the loan would have run. The effect is the same as earning the loan's interest rate on the money you prepaid, and nothing can take that saving back.
Take a ₹50 lakh loan at 8.5% over 20 years. The EMI is ₹43,391 and the total interest is ₹54,13,879. Pay ₹5,000 a month on top of the EMI and the loan clears in 15 years and 7 months, four years and five months early, with ₹13,89,250 less interest.
What investing the same money might earn
Invest that ₹5,000 a month instead and the result depends on the return. Over 20 years, ₹12 lakh of contributions grows to ₹31,57,201 at 8.5% a year and to ₹43,67,865 at 11%.
Those figures cannot be set against the interest saved directly, because prepaying has a second effect. The loan ends early, and for the last four years and five months the person who prepaid has no EMI at all. A fair comparison lets them invest their whole ₹48,391 monthly outgo once the loan is gone, and then compares both people at the end of year 20.
The fair comparison
Run it that way and the answer is tidy. If investments earn 8.5%, the same as the loan rate, the investor finishes with ₹31,57,201 and the prepayer with ₹31,21,297. They end up nearly level, which makes sense: prepaying a loan at 8.5% and investing at 8.5% are the same trade.
If investments earn 11%, the investor finishes with ₹43,67,865 against the prepayer's ₹33,13,304, about ₹10.5 lakh ahead. That gap is the reward for carrying market risk for 20 years, and it only arrives if the returns do.
So the loan rate works as a hurdle. Investing wins when you can reasonably expect to beat it after tax. Prepaying wins when you cannot, or when finding out would cost you sleep.
Tax changes the hurdle
Under the old tax regime, interest on a loan for a home you live in can be deducted up to a yearly limit, and principal repayments count towards section 80C. If you use those deductions, part of the interest comes back as tax saved, so the loan effectively costs less than its headline rate and prepaying earns less than it seems to.
The new regime has no deduction for interest on a home you live in, so prepaying earns the full rate. Investment returns are taxed under both regimes. Compare the loan rate after any tax benefit with what the investment would earn after tax.
What the numbers leave out
- Money you invest can be sold if you lose your job. Money you prepay is locked in the house until you sell it or borrow against it again.
- Prepaying before you have several months of expenses set aside trades a manageable loan for a fragile cash position.
- A credit card balance or personal loan at a much higher rate should be cleared before either option.
- A prepayment, once made, stays saved. An investment can be cashed in for something else, which helps when you need the money and hurts when you only want it.
If you prepay, shorten the loan
After a lump-sum prepayment, most lenders let you either keep the EMI and shorten the tenure, or keep the tenure and lower the EMI. Shortening the tenure saves far more.
On the same ₹50 lakh loan, suppose you prepay ₹5 lakh after five years, when ₹44,06,359 is still owed. Keeping the EMI and cutting the tenure saves ₹10,69,153 of interest and ends the loan three years early. Keeping the tenure and cutting the EMI to ₹38,467 saves only ₹3,86,266. The lower EMI feels better each month, but the balance falls more slowly, so interest runs on more of it for longer.
Floating-rate home loans taken by individuals cannot carry a prepayment penalty, so the choice is usually free. Check the terms if your rate is fixed.
A middle path
Plenty of people split the difference. They keep the emergency fund intact, invest steadily for long-term goals, and send windfalls such as bonuses to the loan, which keeps part of the guaranteed return and part of the growth. Run your own numbers in the loan prepayment calculator and the SIP calculator with a cautious return for the investment. The gap between the two results is the extra you would be taking risk to earn.