Factors to Consider Before Home Loan Prepayment

home loan prepayment

When Sushma and Rajiv applied for a home loan, Sushma had remarked that they would try to prepay their home loan as soon as possible. However, Rajiv had opposed the idea of prepayment. So who do you agree with: Sushma or Rajiv? Is it a judicious decision to prepay a home loan?

 

Prepayment is a facility which allows loan borrowers to repay their loans (either full or partial) before the completion of the loan tenure. Given the Indian aversion to debt, home loan borrowers may often prefer to prepay their loans. However, this is not always a prudent decision, and one should consider the following factors before taking a plunge.

  1. Adequacy of funds

Before proceeding with home loan prepayment, make sure you have kept sufficient funds aside for your other financial goals, like marriage, travelling, child’s higher education etc. In any case, you should not overextend yourself to prepay your loan. Further, it is imperative to ensure that you have surplus funds kept aside for exigencies, like medical condition, job loss, etc.

  1. Earnings from investments

Before prepayment, it is inevitable to know the returns available with different investment avenues. If you have the opportunity to earn interest from an investment higher than the home loan interest, then it is wise to invest your surplus fund rather than using the same towards prepayment.

A housing loan is a long-term loan, and in order to make a right comparison of home loan cost vis-à-vis investment returns, you should consider equity investment, which is a long-term investment plan. In the case of equity investments, the longer the tenure of the investment, the lower will be the risk and vice versa.

To arrive at the right decision, you should consider the net cost of a home loan after tax.

Parameters Home Loan
Rate of interest 9.50%
Tax benefit Yes
Tax saving at 30% 2.85%
Effective interest cost after tax benefit (%) 6.65

According to our above calculations, a loan at 9.50% effectively costs just 6.65% if you fall in the 30% tax bracket. If you can yield higher returns through investments, it is fruitful to invest the surplus funds and continue with your home loan. Over the years, mutual funds have generated returns at a compound annual growth rate of above 12%. In addition to mutual funds, you can explore other investment avenues also where post-tax returns are high.

Note: Every investment comes with risk. So the returns on your investment might fluctuate over time. Be cautious while investing.

 

  1. Loan stage

Usually, during initial years, your EMI outgo mainly consists of the interest component. As a result, prepayment of your home loan in the mid and later stages may not give you the complete benefit on interest.

  1. Rate of interest

Interest rates of housing loans are much lower than other loans, including personal loan and car loan. Therefore, if you are keen to lower your debt burden, it is good first to prepay those loans that carry high-interest rates as against home loans.

Type of Loan Rate of Interest
Personal Loan 10.65%-24% per annum
Home Loan 8.3%-11.75% per annum
Car Loan 8.40%-13.25% per annum

Note: The interest rate is given for an indicative purpose only.

  1. Tax deductions

With housing loan, you are entitled to claim tax deductions up to Rs 1.5 lakh per financial year on repayment of principal amount. You can also get tax benefits on the interest paid.

Further, with the government’s focus on ‘housing for all’, tax benefits on home loans are likely to increase in the future. However, be ready to part ways with tax benefits in case of prepayment.

To sum up

There is no rule which says that the entire surplus amount must be diverted towards home loan prepayment. You can always bifurcate it and use it both towards investment and prepayment.

Further, if the thought of outstanding home loan is troubling you, then instead of prepayment, you can consider buying home loan insurance or term insurance as well, which will safeguard your family from repayment obligation in case you meet with an unfortunate event. Most importantly, the decision to prepayment depends on individual circumstances and should be dealt with accordingly.

As said by Warrant Buffett, an American investor, risk comes from not knowing what you are doing. So make sure you know and evaluate all the factors before going ahead with home loan prepayment.

 

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