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. Prepayment of home loan 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.
Prepayment of Home Loan – 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 ?
Prepayment of Home Loan – 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 ?
I will not comment on the numbers. I will just comment what I will do that will make my comfortable.
In both cases, if I am comfortably paying the EMI, I will not prepay the loan. I will use this surplus/windfall to jumpstart my investment. I will try to prepay the loan, but not through this surplus. I will prepay it through my regular income from time to time.
If EMIs are stretching my budget may be I will consider using a part of surplus to reduce my EMI burden.
I am not a salaried person, I am an independent professional. If I work more, I make more money. I work best when I am slightly stretched. I will use the surplus for investment to make myself comfortable that I have added to my retirement / children education corpus. And I will work more to prepay my EMIs through my regular income from time to time.
I don’t know if it is financially sound decision, but for me, it is a psychologically sound decision.
@Sachin,
Very interesting feeback. But if you take Case 1 in the above example you would save a lot of money. Whats your view?
Yes, you are right, I would save a lot of money if I prepay. But I am not against the prepayment. It does not have to be option 1 or option 2. If I am going to put the surplus in a bank FD then definitely I should prepay.
What I am saying is that you should try to prepay your loan through your regular income. If your regular income is not enough to prepay the loan, think of ways to increase your regular income or again postpone that 7 day Kashmir trip that you had be been planning for last five years or don’t upgrade your car.
Using the surplus for investment and prepayment of the loan are not mutually exclusive. You should try to do both.
By the way, where did this surplus amount come from? Was it your saving so far? FD? Mutual funds? Stocks? Your father/uncle gave it you? (How I wish!) If it is a part of your savings how do you calculate the surplus?
May be I am biased. At the age of 43, I do not have a home loan or car loan now. I have already paid them ( at the expense of saving – I always thought finish the loan first then start investing – my mistake). Yes I have loans for my professional requirements. But now that my kids are growing up, suddenly I find that I have not accumulated enough money for their education and faced with the prospect of creating this corpus in next 5 – 7 years, which limits the choices. For example, education in a medical college with capitation fee is definitely out. I simply cannot afford it.
Each to his own, I guess
Your answers carry a lot of maturity and practical scenarios Sachin so keep contributing here.
The surplus come could from a bonus or refund of money from somewhere – but not at the cost of savings.
I get what you are saying – one shoudl try probably both – use surplus for savings and prepayment.
I don’t think you are biased but you are very practical – too many loans can daunt a person and one cannot run his life at the back of calculations as well.
If physiologically it lets one sleep well at night, prepayment of loans is the way to go.
But then one can also argue that in case of no prepayment, the money could be saved for future goals – but as you rightly say, to each his own !
Agree, prepayment should not be from savings or at the cost of other critical goals like child education or retirement corpus.
Sachin, a psychologically sound decision might not be better than a financially sound decision but you suggest that you will still take it ?
I recommend you plant in your figures in the sheet and then check for savings. If they are huge, then you might dither from your decision 🙂
Let us know how it goes.
Thanks for this article, i was looking for answers. I will go with pre-payment of home loan, infact i did that to my home-loan few years back. I did pay a penalty for pre-payment but then i knew it would save me money. Case Study 1 in the above example is similar to what i did.
I think the article suggests that pre-payment might not really be favorable – so why go for it ?
If that’s what give you mental peace, go for it! What’s the point of investment that cannot give you mental peace?
I am currently happy with my position because I did some prepayment and now I am bearing interest of 1.5 lakhs. When interest rate will be revised I will probably do some more prepayment in order to keep interest down to 1.5 lakhs.
My focus right now is to build a corpus equivalent to balance home loan.
Really Interesting Article.
one Question:
I Guess Interest Earned through various INVESTMENT AVENUE is again taxable.
Gains from FD, RD, MF etc.. are taxable if I am correct.
Share your thoughts
Yes, in fact that is something I was expecting someone to raise so great find there Rama !
Of course, it is taxable, So if you deduct the tax and check for your particular case and let us know the findings, it will be great.
We are looking for live cases and how things look for people who have some amount that can be used for downpayment.
I don’t know whether i could live with this loan burden for 15 years, its a very long period, wonder i would live that long. I would like to have a peace of mind, i don’t want to go to bed daily thinking about my outstanding loan. Moreover the statistics in India say that most people complete their home loan tenure within 10 years, so people don’t to be burdened for a long time.
Ramachandran has raised a very valid point on the tax front.
Lets see if i can do some research and get some data.
It depends where you invest. Investments in PPF, tax free bonds and long term equity MF are not taxable as of today.
Thanks Radhey for providing this data. So, in essence it is a wise decision to invest the surplus rather than prepayment.
I think it is about what gives you mental peace – debt free life or an invested corpus? If my corpus is equal to or more than my loan amount, I’d sleep peacefully because I know in worst case scenario of losing regular income I am in a position to continue EMIs or clear off loan somehow.
Also, I think it is a good idea, if you have surplus money, to prepay in such a way that it keeps the interest amount around 1.5 lakhs so that you can enjoy the best of both worlds.
On your last note, can you elaborate what you mean – so you are saying prepay in such a way that the interest amount never crosses Rs 1.5 lakhs – how much does one lose with that amount of corpus not growing and with reduced tax savings in the future – I am suddenly all ears !
My balance loan was around 20 lakhs and I was paying annual interest of some 2+ lakhs. Since I could get tax exemption on 1.5 lakhs, I thought extra 50k is not giving me any benefit and is a total waste. I had some surplus money so I did a prepayment and annual interest came to 1.5 lakhs.
I didn’t do any detailed calculation but my logic behind prepayment was if I invest in FD [since I was not into equity at that time] of 9.5%, I’d be getting around 7-7.5% after tax. My home loan interest rate is more than that so better pay off the loan.
Very interesting calcualtion and discussion is going on here :). The outcome is really amazing.
I have one question here. In case not pre-paying the surplus amount is considered as investment and the tax saving part is considered – double benfit and that’s what we see in results :). Cool. When a person is pre-paying home loan, his EMI is going to reduce right. In that case, the money he saves will be little more every month, so if this saved penny invested every month (though the route of SIPs or RD or whatever preferred by investor), at the end of (loan duration) years how far it can grow……. would it be really a great number?
I don’t have much knowledge about what happens when we pre-pay the home loan so correct me if my direction is wrong.
If the question is fine, then would request readers here to throw some light and Radhey can help calculating it in a better way.
I am considering that money saved from lessen EMIs being invested. If the investment goes good, the person who pre-payed will be happy having good sleeps (I am going to hit the bed after this comment 🙂 ) at night with few sweet dreams of how to spend his investment ;).
When you pre-pay any amount the EMI figure does not come down. It is the duration of loan that will come down.
Doing a pre-payment reduces the amount of interest credited to your home loan account since most banks calculate home loan interest on daily/monthly reducing balance.
Yes, but one has an option to keep the tenure same and reduce the EMI as well. How much savings will we get in that case ?
Nice catch Chirag – I think it is important to note that the money saved via EMIs will also grow.
If anyone has done those calculations, can they say what is the outcome ? Vivek, one for you ?
Readers,
Consider this. My current EMI is 16500/month. This sounds big money to me now but considering current inflation rate, what will be the actual value of this money after 10 years? It will be roughly Rs. 9000.
I am a salaried person and with continues increments of 10% every year,the salary will be 2.5 times of the current salary.
Just think again; this mammoth figure of 16500 may not look mammoth after your salary is increased 2.5 times.
Caveat: I am considering a Fixed rate of Interest for EMI as I have a fixed Rate on Loan.
Excellent analysis Lucky.
So if we think that , so does it mean that we should have opted for a longer tenure.
A = 25 year’s. B = 15 year’s tenure
A gives an opportunity to use some amount to invest, which in case of B, you would have endedup paying as EMI.
So if we think that investing is better than prepayment, does it mean that we should opt for a longer tenure.
A = 25 year’s. B = 15 year’s tenure
A gives an opportunity to use some amount to invest, which in case of B, you would have endedup paying as EMI.
Not sure I understand the calculations, can you elaborate further. I think it needs to be taken on a case to case basis to justify this.
Everybody posted very good commet’s . I my view we sholud plan i.e
Prepayment only up to get befefit of 1.5 lacs intrest deduction in tax and and rest amaunt we sholud invest in PPF ( 8.8% tax free).
Why do you say that Abhishek – what is the logic ? Why invest in PPF ?
Hi
My question is.. If u prepay your loan in India , I think loan tenure decreases. But the amortization schedule is same. So the interest is not decreasing though you are applying extra amount towards principal. It mere waste if you are not decreasing the interest and finally u would only decrease the tenure of the loan. Having a home in USA and India , this is what I knew from my loan in USA. If this prepayment decreases interest , then I will clearing off the mortgage for my home in India in couple of months as I have little to pay .
i dont know, if this post is old or new(no date written anywhere), but i would like to add my views. i think the above calculations did not consider the growth of interest saved as an investment.
in both the cases, the investments for the surplus amount(if not used for pre-payment) has been taken for whole duration of loan. but if one prepays the amount, his overall tenure is also reduced along with the total interest saved. this means that total interest saved , when invested for the time we reduce from our total tenure, would have given more returns…if someone could do the exact calculation?..