Bonus at the workplace or an unplanned income from family members are usually substantial. However, receipt of such substantial money can always create a dilemma of whether to invest the sum into SIP or pre-pay home loan. In the case of a lack of a home loan, the answer is pretty straightforward. But, if there’s the burden of a home loan, it can lead to a dilemma. And, the answer differs from person to person, however, the variable to determine the category could be the same. Thus, let us study what these variables are that decide the optimum outcome of this dilemma.
Age: First, age is a huge determining factor, since it decides the earning capacity of an individual. Say you are in your mid-30s and hold a secured job, you can opt for a lump-sum investment subject to other variables. However, if your age is in the late 40s or early 50s, you may want to close your home loan and reduce the liability before your income source extinguishes.
Liquidity or emergency fund: An absolute must in today’s date, but again a home loan can cause a serious hole in your financial planning. This indirectly deters the creation of any sort of emergency fund or liquidity. Thus, this surplus income can act as a stop-gap solution, and help you create a temporary fund in case of emergency. However, this option must be utilised keeping in mind other variables covered in this article.
Risk appetite: Investing in mutual funds always carries a risk to the stock market. Therefore, risk-averse investors might not want to test the double loss in mutual funds along with home loans hanging on their heads. In case of limited risk, it is appropriate to close the outstanding loans before going for investment in even moderately risky opportunities.
Tenure of investment: When there are multiple loans - car, personal, education, etc - apart from the long outstanding home loan, the surplus fund might be better utilised in closing one of these instead of pre-payment of the home loan. Since a home loan is the cheapest among all loans, investors can sustain it for a longer term. Even when there are no loans apart from home but the investor might need money for say renovation or a wedding, then also these surplus funds could be utilised.
Income Tax: Possibly the greatest benefit against pre-payment of home loan. It can help you with up to Rs 1.5 lakhs allowable deduction for principal repayment and an additional up to Rs 2 lakhs of benefit for interest repayment. Thus, the aggregate tax benefit per borrower goes up to Rs 3.5 lakhs. Now, if you are in a 30% tax bracket, with a gross income of Rs 15 lakh per annum, you will be saving almost a lakh in tax. However, since the limit of Rs 1.5 lakhs under 80C is available through other options such as PPF, school fees, life insurance premium, etc., the additional Rs 2 lakhs for interest benefit could be the actual benefit.
Psychology: With many risk-averse investors do not like the burden of huge liability on their heads. Lack of job security, single earning members, risky business nature or even lack of investment knowledge could lead individuals to pre-pay home loans instead of investing in mutual funds. Even an absence of sufficient life cover coupled with a sole source of income should opt for pre-payment of a home loan. While some investors even without any deteriorating conditions opt for pre-payment simply to retain sound sleep. Thus, psychology could play a major deciding factor in the dilemma.
Returns: This variable gives the most practical answer among all. To put it simply, one should only opt for a mutual fund over the pre-payment of a home loan if the post-tax income from a mutual fund is higher than the effective cost of a home loan. Effective cost is the total EMIs of a home loan reduced by tax saving subject to the tax slab of every individual. To see it through a macro perspective, an outstanding loan of Rs 70 lakhs at 9.5% interest brings to Rs 6.65 lakhs now after deducting the Rs 2 lakhs benefit of interest repayment it comes down to Rs 4.65 lakhs. So, a Rs 4.65 lakhs interest on a Rs 70 lakhs loan generates an effective interest of about 8.64% even for Rs 30 lakhs tax-bracket individual. In addition, these figures could change if the loan is jointly shared and both can enjoy the Rs 2 lakhs tax benefit. However, if the total loan outstanding goes below Rs 20 lakhs, then you may not be able to fully utilise the Rs 2 lakhs interest benefit, since the maximum interest paid in the whole year will be less than Rs 2 lakhs. In such a case, it is not advisable to pre-pay the loan and instead opt for a mutual fund.
To conclude, whether pre-pay a home loan or invest could vary from person to person given the above factors. Hence, it may be wise to evaluate each variable and then decide the factor.
(Viral Bhatt is the Founder of Money Mantra — a personal finance solutions firm)
