Should I pay off my home loan or continue investing in the hope of decent returns? This is the most intriguing question which keeps playing on the mind of a large number of home loan takers, particularly in a falling interest rate regime like the current one. After all, when returns on investment avenues are not guaranteed or the current yields are all set to fall further, then doesn’t prepaying high-interest or longer-duration loans like a personal loan or a home loan seem to be a better option? However, is doing that a wise proposition?
Industry experts say, investing money or prepaying a loan/loans depends on the choice of investors. There is no denying the fact that currently home loan interest rates are the lowest in a very long time. This has its own advantages. For instance, when rates fall, you get the ideal opportunity to make pre-payments, because, at a lower rate, your pre-payments will have a higher impact on reducing your long-term interest.
Let’s understand this with an example:
Let’s say you have taken a floating rate home loan of Rs 35 lakh at an interest rate of 8.50% for 20 years. Your EMI is Rs 30,374, and your total interest over 20 years is Rs 37.89 lakh. In the first 12 months, you have paid Rs 2.95 lakh as interest and the rest as principal. At this point, your loan balance is Rs 34.30 lakh.
Now you decide to pre-pay approximately 10% — Rs 3.5 lakh — over and above your 13th EMI. This would reduce your total loan interest to Rs 26.75 lakh – thus, saving you Rs 11.14 lakh over the long term, assuming a constant rate of interest and no further pre-payments.
However, “now examine this in a situation where the pre-payment happens after an interest rate fall. After 12 EMI payments, your interest rate reduces to 8.25%. Your loan balance is Rs 34.30 lakh, and your EMI reduces to Rs 29,841. Here, you pre-pay Rs 3.5 lakh. This reduces your total interest, including the interest paid with the first 12 EMIs, to Rs 26.09 lakh, which gets you additional savings of around Rs 66,000, or a little more than two EMIs,” says Adhil Shetty, CEO, Bankbazaar.com.
Therefore, pre-paying when the interest rates are low have a much higher impact on reducing your loan balance, and if you pre-pay regularly while the interest rates are falling, you’ll accelerate your way out of debt.
Should you invest or prepay?
Now the question, whether you should use your savings to invest or pre-pay during a falling interest scenario?
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According to industry experts, there’s no one-size-fits-all answer to this, and you must do whatever is necessary to strengthen your finances.
“During a downturn, it’s absolutely essential to maintain liquidity and savings, and so it would be unwise to use all your savings to pre-pay your loans. You could meaningfully allocate your savings into multiple buckets, using one to make a part-payment on your loan, and the others to make investments as per your investment strategy. This way, you can use your savings in diverse ways and have an impact on not just your loan balance, but also on your wealth creation,” advises Shetty.
Some financial experts also observe that although the decision to prepay the home loan depends upon the unique risk profile and financial situation of every individual, however, given the relatively soft interest rates and the significant tax advantages of home loans, it would usually be beneficial for an individual to continue with the home loan.
“Accumulated savings should be invested rather than used for retiring home loans. Returns on well-managed equity and mutual fund portfolios have historically been much higher than the interest paid on home loans. On top of that, tax benefits under Section 80C and Section 24 of the Income Tax Act make the probability of beating the loan hurdle rate even higher,” says Ashish Kapur, CEO, Invest Shoppe India Ltd.
When paying off loans is a better idea
This is, however, not always true. For instance, in case a person already has other loans as well, then reducing some leverage across the board is a good idea. Also, “if you are risk averse and generally park your money in fixed deposits and other safe and low-return instruments, then you are certainly better of using your surplus earnings to reduce personal debt. Age of the person also influences the decision in this case. Closer to retirement, it is better to try and finish all liabilities. Also, if you are having health issues, then stay away from debt,” says Kapur.
Housing loan due to the tax advantages is certainly the most preferred mode of debt. Therefore, in terms of preference, it should be paid back only after other liabilities have been extinguished, such as credit card dues, personal loan, car loan, among others.
The facts mentioned above make it clear that if you have age on your side, have no medical problems and have an exposure to financial markets, it makes sense to continue with your home loans. There can, however, be no rule on this and each individual needs to decide based on his/her profile, age, risk-taking capacity and several other criteria.