We get quite a few queries from our investors who have taken home loan and now want to know if they have some surplus savings then does it makes sense for them to pay off the loan first or invest in Mutual Funds.
Invest vs Prepay Home Loan
As your salary increases and the EMI remains the same, your savings also increase. This surplus savings can either be used to invest more for the future or increase the EMI to pay off the loan faster. Some people either increase their EMIs or use their savings to accumulate a corpus to pay off the loan sooner in lump sums. Some people simply increase their SIP investments and let their EMIs run as per the schedule.
What should you do?
Step 1. Do you have an emergency fund?
Check your existing savings. If you don’t have any substantial savings, then you should definitely invest the surplus in Debt Mutual Funds and build an emergency savings corpus of about 6 months of your living expenses (including all EMIs) first.
Step 2. Do you have any short term money needs within the next 2-3 years?
After building an emergency fund, take stock of any other short term money needs that are going to come up in the next 2-3 years. If you don’t have enough savings to take care of them then invest in Debt Mutual Funds or make an FD for the same.
Step 3. Invest vs Prepay? Depends on your risk profile.
If you already have enough savings for emergencies and short term needs then given that your home loan interest would be in the 9-10% range and investments in Equity Mutual Funds have given returns of 12-15% in the long term in the past, you can invest the surplus in Equity Mutual Funds provided you have the risk tolerance for dealing with the ups and downs of the stock market. This should be done only if you are planning to stay invested for more than 5-7 years because equity investments can be expected to give good returns over the long term only. However, if you have a low risk tolerance, then it is better to use the surplus to pay off your home loan faster.
Remember, investing the surplus only makes sense if all or most of it can be invested in equity (e.g. via Equity Mutual Funds) which in turn means you will lose a substantial sum of money in case of a market crash if and when it happens eg in 2008, the stock market (and Equity Mutual Funds) declined by 50%. Can you sit through such a loss without exiting in panic?
If yes, then you can invest the surplus savings in Mutual Funds.
If no, pay off your loans after creating an Emergency Fund and investing for your short term needs.
Take our risk profile questionnaire here to see what is your risk appetite. Pre-pay your loan if you fall under any risk profile apart from High Risk. If you have High risk profile, you can consider investing this money in Equity Mutual Funds for better long term returns.
There are a few things to keep in mind before paying off your loan or increasing your EMIs:
- Check the loan agreement with your banker to know if the agreement allows prepayment or increasing the EMIs.
- Check the prepayment penalty. The lumpsum prepayment that you do gets deducted from the principal amount generally. So you’ll save the interest that you were supposed to pay on that amount. If the net present value of interest saved is equal or higher than the prepayment penalty, it makes sense to prepay.
Loan transferability or refinancing is a common feature that most of the loans have now, especially home loans. This is to help you take benefit of the lower interest rates on new loans.
If you have taken a loan say 10 years ago at 10% per annum, and if the prevailing interest rate is 8.5% per annum in the same bank or in any other bank, you can transfer your loan to the one with lower interest. You can check your loan agreement or with your banker if this is indeed possible with the loan that you have taken.
Loan insurance is similar to a term insurance. It covers the risk of the burden of EMIs falling on your dependants. You are covered under this insurance till the period of your loan repayment. Once the outstanding loan amount has been paid, the insurance term expires. However, if the individual who is paying the loan expires within the loan term period then the loan insurance can be claimed by the family to repay the outstanding loan amount. This ensures that the house or the other assets as collaterals are not seized by the bank.
It’s highly recommended to have a loan insurance if you don’t have already. If you are planning to purchase a term insurance then it’s recommended that you calculate the cover amount after adding the total outstanding amount of the loan. If you have already purchased a term insurance without covering for the outstanding loan amount, then purchase a loan insurance. Generally loan insurances are provided for long term loans like Home and Personal loans.
Sometimes it’s sold along with the home loan and is mandatory. You can check with your loan provider whether you have been given the insurance along with it or not. If you haven’t, you can contact them for the insurance.
Tax Rebate Under Section 24 and 80C
If you have taken a home loan for purchase of a house or for construction of the house which is expected to be completed within 5 years, then make sure you are claiming all the tax benefits that come with it. EMIs that you pay have two components - interest and principal repayment.
The interest portion of the EMI paid for the year can be claimed as a deduction from your total income up to a maximum of Rs 2 lakh under Section 24. For rented out property, there is no upper limit for claiming interest. This deduction can be claimed from the year in which the construction of the house is completed.
The Principal portion of the EMI paid for the year is allowed as a deduction under Section 80C. The maximum amount that can be claimed is up to Rs 1.5 lakh. But to claim this deduction, the house property should not be sold within 5 years of possession. Otherwise, the deduction claimed earlier will be added back to your income in the year of sale.
To claim these tax deductions, you just need to ask your banker for the breakup report between interest and principal payments.
There are some other tax deductions as well which you can check here. Do consult a CA for filing taxes.