Home loans have certain peculiarities that separate it from other debts and they are called good loan because it is taken for creation of appreciable asset i.e. a house. First, home loan carries the lowest interest rates. Second, we get tax benefit on both interest as well as principal repayment.
If you have an outstanding home loan, and happen to have just received an annual bonus or any other lump sum payment, should you use it to prepay your loan? Or, should you invest it to meet some other goals?
Assess the following conditions to arrive at the right decision.
The first variable to be considered is psyche: some people may not be comfortable with a large housing loan and to reduce their stress they may want to get rid of the loan burden at the earliest. For them, settling the question of how to use their bonus is simple: just pay off the loan.
Tax benefit is the next variable. If a home loan does not seem like the sword of Damocles hanging over your head, it makes sense to continue with the regular EMI schedule. This is because of the tax benefits that a home loan offers. The principal component of the EMI is treated as investment under Section 80C. The interest component is also deducted from your taxable income under Section 24 with certain limitations under the Income tax law.
The third key variable is returns from investment of the lump sum at hand. 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 after availing tax benefit.
There are some home loan products that provide an overdraft facility of sorts and help you maintain liquidity. All you have to do is to park the surplus money in these products and not bother with whether it’s a prepayment or not. It’s like prepayment with the option of taking out that money, in case you need it in future for personal use or for investment purpose. The strategy of maintaining the housing loan interest close to Rs 2 lakh per annum can also be managed by these special loan products. And even if you are going to invest, the SIPs can go from this account.
Apart from above, we should have a holistic approach to our finances before we take the decision, either in investing or prepaying our loans. We should ensure that following important aspects about our finances has been taken care before we take the repay or invest decision.
- Contingency fund: Check that you have adequate amount in your contingency fund, which may typically have 3 to 9 months’ worth of expenses including EMIs and SIPs towards your financial goals invested in liquid funds.
- Payoff high interest bearing debts: Besides home loans you may have other loans carrying higher rate of interest. Next aim should be getting rid of bad loans like loans against depreciable assets such as Car loan, personal loans, credit card dues etc.
- Financial freedom fund: Retirement planning is no doubt an important financial goal in your life for which having provision is must because for all the other goals we may get loans but we will not get loan for retirement.
- Goal based investment: Have systematic investments to match your time bound goals.
The Bottom Line
After considering the above we may do mathematics to decide our priority of paying off home loans or investing. You may discount the home loan interest with the tax benefit and arrive at net rate of interest and compare it with the post tax return on investments.
The best way to pick a strategy is to pick one that can help you to achieve your financial and personal goals.
The writer is a chartered financial analyst (ICFAI).
- If you’re wondering what type of strategy is right for you or if you simply need help implementing desired strategy, you may find it helpful to talk to a financial advisor. It is crucial here to find the right advisor.
We at FinACTS Solutions can help you with our free personalised planning services.