Are You In A Hurry To Prepay Your Home Loan?

Are You In A Hurry To Prepay Your Home Loan?

Before you quickly decide to get rid off your debt – in this case a home loan – consider carefully the mathematics involved to find out if it would be better to invest in a mutual fund alongside paying the equated monthly instalments

Consider this scenario: Vikas Kumar is a senior executive in a multinational company. Few years back he had purchased a house on loan and is currently paying interest on that loan at a rate of 9 per cent every year. He is comfortably paying his equated monthly instalments (EMIs). In the last few years his salary has increased and he has now accumulated some cash. The big dilemma with him is whether he should invest his savings in mutual funds or should he prepay his loan? This is a situation that many of us who are salaried face at some point of time. The most mundane response in this situation is to pay off your debt.

Tax Benefits on Home Loan The following pointers gives you the tax benefits under the corresponding sections of the Income Tax Act, 1961.

Income Tax Act Maximum Deductible Amount Section 24 : Rs. 2 lakhs for self-occupied house. No limit for let-out property Section 80C : Rs. 1.5 lakhs from principal, including stamp duty and registration fee Section 80EE: Rs .50,000 additional interest for first-time buyers .

The relevant details of the above sections are given below:

☛ If your property is a self-occupied one, you can claim a maximum deduction of Rs. 2 lakhs.
☛ If you let out your property on rent, you can claim any amount you have actually paid as interest. There is no limit.
☛ If you are a co-borrower and also co-owner of the house, you can each claim up to the maximum deductible amount under this section.
☛ The deduction of Rs. 2 lakhs applies only if you complete the construction within five years. If the construction is not completed within this period, you can claim only up to Rs. 30,000.
☛ If the property is given on rent, you can claim any amount actually spent as interest, whether it is completed or not.

Nevertheless, home loans have certain peculiarities that separate it from other debts. First, a home loan carries one of the lowest interest rates and hence does not hit your pocket hard. Second, you get tax benefit on both your interest as well as principal repayment.

Hence, you should have a holistic approach to your finances before you get aggressive on investing and writing out a cheque to buy some mutual fund schemes or prepaying part or the entire home loan. There are other important aspects of your finance that you should check before you invest or prepay your mortgage.

1. A fully funded emergency fund: Before you think of any other option of deploying your surplus cash, check that you have adequate amount in your emergency fund. You should typically have three to six months’ worth of expenses including EMIs and SIPs towards financial goals in a liquid fund that you can access at the time of emergency.

2. Pay off all the high-interest bearing debt: Besides the home loan you might also be availing other loans such as car loan, personal loan or credit card dues. These loans normally carry higher interest rate compared to home loan. Therefore, after creating your emergency fund, you should aim at getting rid of all your high-interest-bearing loans.

3. Save for your golden days: There is no doubt that retirement planning remains the most important financial goal of your life. Hence, without fail you should at least contribute 10-15 per cent of your income towards building your nest egg.

Once you have taken care of all the above it’s now time to do hard mathematics to decide which is better – paying your home loan early or investing in mutual fund or elsewhere.

Running Mathematics We will work with different scenarios and check when it is better to prepay a home loan and when to invest. For this we have assumed that you have a mortgage of Rs. 50 lakhs with an interest rate of 8.7% that is set to be paid off in 20 years. There is another angle to a housing loan. The principal and interest payment get tax benefit, as indicated in the table above, and you are being taxed at the highest tax rate of 30 per cent.

CASE 1

Based on the above assumption, your EMI will be Rs. 44,026.15. For the entire period you will pay interest of Rs. 55.6 lakh, and the total outgo would be Rs. 1.05 crore. It is assumed that you are being allowed to take the benefit of interest on this housing loan till the loan tenure and all the savings have been invested in a mutual fund. Hence, out of the total payment of Rs. 5,28,313 (44,026.15 x 12) every year you make, the interest component will be higher in the initial years and decline gradually. The total savings would be around Rs. 10.41 lakhs in 20 years in terms of tax. Assuming tax rate of 30 per cent. It implies that if you were not availing the benefit of home loan interest, you would have been paying Rs. 10.41 lakhs in tax. If we assume that it is invested in an instrument yielding 6 per cent return and after tax the actual yield in your hand is 5 per cent, the total value of your investment would be Rs.1.54 crore at the end of 20 years. Finally, if your EMI and investment are considered as outflow, your total outflow would be Rs. 1.15 crore and your investment value alone would be Rs. 40 lakhs [1.54 Cr. - 1.15 Cr.] more than your total outflow.

CASE 2 : Pay Home Loan in 15 years

Let us assume that you are someone who believes that debt is a burden on you and wants to increase your EMI amount in order to complete paying your home loan. Therefore, you have decided to pay your home loan in 15 years and you have increased your EMI accordingly. In this scenario you will have to pay EMI of Rs. 49,824.9 and the total interest outgo will be Rs. 39,68,482.82. Hence, the total payment you have to make is around Rs. 90 lakhs, which means a saving of around Rs. 15 lakhs in interest outgo. Again, assuming the saving of tax is invested in securities earning post-tax yield of 5 per cent, you will get an amount of Rs.1.4 crore at the end of 20 years. In this case, your total outflow would be Rs. 96 lakhs with inflow of Rs. 1.4 crore and hence your net inflow would be Rs. 44 lakhs.

In addition to increasing your EMI you also have the option to invest the amount that you used in increasing your EMI in some safe mutual funds yielding you a return of 5 per cent post-tax. In that case you invest Rs. 5,798 (Rs. 49,824.9 – Rs. 44.026.14) every month in MF, which will yield you Rs. 23.5 lakhs at the end of 20 years. Against this what you will lose in interest savings of around Rs. 16.32 lakhs. Which means you would still gain Rs. 7 lakhs (Rs. 23.5 – 16.32 lakhs). Hence, it does not make sense to increase your EMIs. Instead, it makes sense to invest the extra amount so that you will have more money in your hands at the end of your 20-year home loan tenure.

The table below shows your investment value over and above what you pay in home loan for 20 years. It is assumed that you are not prepaying your home loan and instead invest that amount. The row shows different interest rate on home loan and column shows the year of loan you have availed. It clearly shows if you have longer duration of home loan and lower interest rate, it is better to invest.

CASE 3: Pay Home Loan in 10 Years

Nevertheless, you are someone who is not comfortable with debt and wants to get rid of it as soon as possible. You may be aggressive and would like to pay it off. So you have decided to pay your home loan in 10 years and you have increased your EMI accordingly. In this scenario you will have to pay EMI of Rs. 62,528 and the total interest outgo will be Rs.25,03,474. Hence, the total payment you have to make is around Rs.75 lakhs, a saving of around Rs. 30 lakhs as compared to the first scenario. Again, assuming the saving in the tax is invested in securities earning post-tax yield of 5 per cent, you will get an amount of Rs.1.1 crore at the end of 20 years.

In this situation your total outflow would be Rs. 78.69 lakhs with inflow of Rs. 1.1 crore and hence the net inflow would be Rs. 32 lakhs. Here again we will consider a scenario where instead of increasing your EMI you decide to invest in some safe mutual funds yielding you a return of 5 per cent post-tax. In that case you invest Rs. 18,502.80 (Rs. 62,528 – 44,026.14) every month in MF, which will yield you Rs. 75 lakhs at the end of 20 years. Against this what you will you lose is interest savings of around Rs. 30.32 lakhs. Which means you will still gain Rs. 45 lakhs (Rs.75 – 30.32 lakhs).

To Prepay or Invest

The above analysis clearly shows that you should not be in a hurry to prepay your home loan. Instead you should invest the extra amount in mutual funds or other such avenues that suits your risk return profile. So what is the reason that investment makes more sense instead of prepaying the loan?

There are two reasons why investment is preferable. First is the tax benefit that you get on the principal and interest on a home loan. So if you fall in the highest tax bracket and your effective interest rate is around 6 per cent considering the tax benifit you get on interest payment while paying your home loan for the first 14 years, it increases gradually as your interest component declines. Any other investment for the same period will be paying more than this and moreover the compounding impact starts to kick in and hence investment becomes a better option even at lower rate of returns.

In case your home loan is carrying higher interest rate of say around 11 per cent and you fall in the 20 per cent tax bracket, our analysis shows that it make sense to prepay your home loan as it will help you to save Rs.8.63 lakhs. Besides, the longer the duration of your home loan the better it is to invest rather than repay, as our analysis shows that if you have a shorter duration home loan, it is better to prepay your instead of investing. The conclusion is that Vikas Kumar should instead invest in a mutual fund rather than prepay his home loan.

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