For the average Joe, one of life’s biggest financial investments is purchasing a home, and probably the best way to make this dream come true is through securing a home loan.
As you start making payments on your loan (or pay off the EMIs), the next big dilemma comes: Should you prepay your home loan whenever you receive excess funds or invest the amount to grow your wealth?
The choice isn’t an easy one. Your decision might impact your long-term financial stability and development. Therefore, do not make this decision lightly.
Let us discuss the things that can help you in making an educated decision.
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What is home loan prepayment?
Prepaying a home loan involves paying an extra amount above your normal EMIs (Equated Monthly Installments) to lower your loan amount. This can either lower your EMI burden or decrease your loan tenure, resulting in interest savings. Most banks and financial institutions permit prepayment with low or no charges, making it a popular choice.
For instance, banks like IDBI offer low cost prepayment options, which help borrowers offset their interest burden at a reasonable price. If your lender offers such a facility, prepayment may be a good option to explore.
The case for home loan prepayment
- Reduces interest burden
Home loans typically have long tenures of 15 to 30 years. So, a major part of the EMI initially goes towards servicing the interest. By paying off in advance, you can lower the principal amount and thus decrease the overall interest paid during the loan period.
- Gives psychological relief
Being debt-free is assuring. Should you value financial security and wish to keep fewer liabilities, prepaying your mortgage may be an excellent move toward financial freedom.
- No assured investment returns
It may be tempting to invest your excess money rather than prepay, but investments always entail some risk. In case the return on your investment does not exceed your home loan interest rate, prepayment continues to be the best option.
- Boosts credit score
Paying off your loan ahead of schedule shows that you are financially disciplined, and this can increase your credit score. A higher credit score can also enable you to get favorable terms on future loans.
When investing may be a better alternative
While prepayment of a home loan is good, investing is a better alternative in some situations. Here’s when investing could be a better option:
- When investment returns are higher than loan interest rate
If you are able to invest in options that have a higher rate of return compared to your home loan interest rate, investing may be a better option. Suppose your home loan interest rate is 8% per year, and you are able to invest in equities or mutual funds yielding 12% returns per year; investing would be a more financially rewarding option.
- Tax benefits on home loan interest
As per Section 80C of the Income Tax Act, the borrowers can avail tax deduction of a maximum of ₹1.5 lakh annually on repayment of principal and up to ₹2 lakh annually on payment of interest as per Section 24(b). If you belong to a higher tax bracket, these deductions could cut your tax liability by quite a bit. Prepayment of your loan might lower these tax advantages.
- Liquidity and emergency fund considerations
Liquidity is essential in financial planning. If paying off your home loan ahead of time requires you to drain your savings, you might be short of money in an emergency situation, like a medical emergency or unexpected loss of a job. Investing rather than prepaying can keep you liquid and financially agile.
- Diversification of assets
If most of your money is tied up in real estate, it might be wise to invest surplus funds elsewhere to create a diversified portfolio. A well-balanced mix of real estate, stocks, mutual funds, and fixed-income instruments can help mitigate risks and enhance overall financial stability.
How do you decide: Prepay or invest?
The choice should be made based on a number of factors, such as your investment objectives, your risk appetite, and current liabilities. Below are some important points to consider while making the decision:
- Compare your loan interest rate to investment returns
If your loan interest rate is greater than your anticipated investment returns, prepayment should be a priority.
If your anticipated investment returns are greater than your loan interest rate, investing could be a preferable choice.
- Consider your risk appetite
If you are conservative in risk, loan prepayment gives you certain savings through lower interest outgo.
If you can take high risk, investing provides superior long-term growth potential.
- Consider your financial aims
If you want long-term wealth creation, investing would be the option.
If you wish to have a debt-free life, prepayment would be the rational thing to do.
- Keep a healthy rainy day fund
Before you make any prepayment, make sure you have an emergency fund for at least 6-12 months of expenses. This will provide financial security in the event of unforeseen circumstances.
A balanced approach: Best of both worlds
For most borrowers, a balanced approach is the best — prepaying part of the loan while also investing. In this way, you get the advantages of debt reduction while still accumulating wealth. Here’s how you can plan:
- Pay high-interest debt first – If you have more than one loan (e.g., credit card or personal loans), pay them off first before prepaying a low-rate home loan.
- Utilize lump sum bonuses or windfalls – Use salary bonuses, tax refunds, or surprise windfalls for part-prepayment while saving some for investments.
- Keep making periodic investments – Make sure you are investing in instruments that provide compounded growth in the long run, like SIPs in mutual funds.
Conclusion
Ultimately, it will be a matter of your financial condition, goals, and risk tolerance whether you prepay your home loan or invest. If you need financial security and peace of mind, home loan prepayment can be an enriching option. But if you desire long-term wealth accumulation and greater returns, investing may be the better strategy.