Should you prepay home loan or invest in MF?

Most of us, who have taken a home loan, often wonder if we should pre-pay part of the home loan as and when we do have some lumpsum amount or should we invest it. There is no easy answer to this as this will involve analysing a lot of parameters at the same time. Nevertheless, we will weed out some of the complexities and try to answer this important question here.

There are four important parameters that influence this question. First is the loan amount, second is the rate of interest, third is the tenure of home loan and finally, the expected rate of return from your investment. Another important factor is your tax slab.

We will start with an example where you have taken a home loan of Rs. 30 lakh for 20 years and the interest rate charged by the bank is 8.7 per cent. The EMI for the above loan and tenure comes to around Rs. 26,416 every month. Hence by the end of the tenure, you will be paying a total of Rs. 63,39,765, which is little more than twice the amount that you have loaned.

Now, if we assume that you got Rs. 1 lakh incentive and you do have an option of either to prepay your loan amount or invest in a mutual fund, which on an average generates 12 per cent every year. So in the first case, you prepay your loan amount, after which your total cash outflow would be Rs. 59,55,966, which means total savings of Rs. 2,83,799, i.e., Rs 3,83,799 (total savings) minus 1,00,000 (prepayment).

In case you invest the same Rs. 1 lakh into mutual fund scheme generating 12 per cent every year, at the end of the loan tenure this investment would grow to Rs. 86,1000. Hence, prima facie it seems that investing in MF is far better than prepaying your home loan.

However, there is one more element that needs to be included in this analysis and that is the tax. The tax amount that you save on the principal and interest paid on the home loan. We assume that the investor is placed in the 20 per cent tax bracket and whatever he saves he invests in MF schemes. In case he does not prepay the home loan and invests in MF scheme, total savings by taking the tax benefit on both the principal paid and interest paid on home loan would be Rs. 63,397 every year. In case you prepay Rs. 1 lakh towards home loan total savings would be Rs. 56,559 due to the tax deduction on the principal and interest amount. If the difference between these two is invested in MFs every year, at the end of loan tenure, this amount would grow to Rs. 3.43 lakh.

Therefore, it does not make sense to prepay your loan amount and instead invest in MFs and enjoy the tax benefit you get from a home loan.