Should one prefer pre-pay home loan or invest in MFs?

The latest quarterly number from the realty sector shows that there has been an increase in the number of home sales. One of the reasons for this is the rise in affordability as interest rates have dipped and realty prices remained constant for a while now.  

People, who have taken a home loan to finance their dream home, often ponder whether they should prepay part of their home loan or invest it. It’s not easy to answer this as this will involve analysing a lot of parameters at the same time such as interest outgo, tax status, number of years remaining to pay the loan, and others.   

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 7.4 per cent. The EMI for the above loan and tenure comes to around Rs 23,985 every month. Hence, by the end of the tenure, you will be paying a total of Rs 57,56,325, which is a little less than what you have taken a loan for. 

Now, if we assume that you got Rs 1 lakh as an incentive next year and you do have an option of either prepaying your loan amount or invest in mutual funds. This fund would generate 12 per cent every year. After one year, you will have a balance of Rs 29,72,236. Now, if you pay Rs 1 lakh at the end of one year, your new loan amount will be Rs 28,75,236. Now, in the next 19 years, you will pay a total of Rs 53,62,812.

So, in the first case, you prepay your loan amount next year and after that, the total cash outflow would be Rs 53,65,812, which means total savings of Rs 2,93,513 (Rs 3,93,513 (total savings) – 1,00,000 (prepayment)).  

In case, you have invested the same amount i.e. Rs 1 lakh into a mutual fund scheme, generating 12 per cent every year, at the end of the loan tenure, this investment would grow to Rs 8,61,000. Hence, the primary analysis shows 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 that you save on the principal and interest paid on the home loan. We assume that the investor is lying 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 the MF scheme, the total savings by taking the tax benefit on both the principal paid and interest paid on the home loan would be Rs 63,397 every year. In case, you prepay Rs 1 lakh towards the home loan, the total savings would be almost seven thousand due to the tax deduction on 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, keeping the same return on investment of 12 per cent. 

If we deduct this amount from Rs 8.61 lakh still prepayment does not make sense. Therefore, it does not make any sense to prepay your loan amount. It would be rather far better to invest in MFs and enjoy the tax benefit you get in the home loan.