Should you prepay your home loan if you have a surplus or should you avoid doing that and simply invest that money elsewhere for it to earn returns ? The decision can be taken emotionally with your heart or rationally with your head.
Clearing of a home loan with pre payments helps to reduce your burden. Less debt helps one sleep tight at night, or so you think ! Prepayment of housing loan also means less interest outgo to the lending institution.
But is also means less savings in the form of tax. The biggest advantage of home loans is that it helps you save tax – as per current income tax laws, under Section 80C, Rs 1,00,000/- for principal and under Section 24, Rs 1,50,000/- for interest is allowed for tax deduction purposes.
I got queried on prepayment from a couple of people, so here are two live cases along with the excel sheet I prepared.
Case Study 1
First download the sheet for easy reference.
As you can see, the case is of a investor saddled with around 24 lakhs of home loan at around 11.25% rate on interest for a remaining tenure of approximately 18 years.
The investor is sitting on a pile of Rs 7 lakhs and the question is – should he invest this money in some investment avenues or simply prepay a part of the loan.
Go through the rest of the sheets to understand the cash flows in the two scenarios – one when he prepays his home loan and another when he does not.
Note that you can assume that no principal component is to be used in the calculation by simply setting it to zero.
If the investor were to prepay his housing loan with 7 lakhs, his interest outgo to the lender will reduce and that savings is to the tune of Rs 9,40,639/- over the loan tenure. That is a huge sum of money to save.
But wait – with less interest outgo, there is a loss on tax savings as well which is Rs 69,001 – a pittance amount. So in case the investor prepays, over the tenure of the loan, he saves a new total of Rs 871,638/- which is still a massive amount of savings.
However, if he were not to prepay 7 lakhs, he would pay an extra interest of Rs 9,40,639/- to the lender over the loan tenure but look at how this 7 lakhs would grow. At 15% rate of interest, it would grow to Rs 87 lakhs and at 8%, it would be approximately Rs 26 lakhs.
As you can see, depending on how this 7 lakhs is used, the case for prepayment of housing loan is a bit weak.
So the question is – should you prepay in this case ?
Case Study 2
This is with inputs from reader Vivek.
With 17 lakhs of loan for a remainder of 17 years at 10% rate of interest, does it make sense if the investor has say Rs 2 lakhs of surplus money which he can use for down-payment ?
If you compare the cash-flows again in the two scenarios, you will realize that the interest amount saved is Rs 216,654 in case of pre-payment. Taking into account the net loss of tax savings, the gain is a total Rs 165,384/-. Not much, eh ?
But in case the prepayment is not done, this Rs 2 lakhs will grow to Rs 21.5 lakhs over 17 years at 15% interest rate – even with 8% interest rate, the returns will be Rs 7.4 lakhs.
So even in this case, prepayment leaves less in your hands.
Note that in both the calculations, I have not considered the growth of the money saved from tax or opportunity loss in case the money is lost to the government. If you wish, you can plant those calculations in and share the sheets.
Can you folks review the calculations to point out the errors, what has been missed and how this could be made even more better ?
This will help the two readers and others immensely.
And don’t forget to answer whether you should prepay your home loan or not ?