The Investment vs Loan Prepayment Calculator is a brilliant financial tool designed to solve a common dilemma: should you use your extra cash to invest or to pay off loans early? At its core, this calculator compares the potential returns from investments with the interest savings from prepaying a loan.
How to Use the Calculator
Here’s a simple step-by-step guide:
- Input Loan Details: Start by entering the specifics of your loan, including the loan amount, current EMIs, and loan tenure.
- Completed Tenure: Enter the number of years you have already repaid the loan.
- Extra EMI Amount: Choose the amount of additional EMI you plan to put up
- Hit Calculate: Once all the information is in, press the calculate button to see the magic happen. The calculator will display the potential future value of your investment versus the interest saved by prepaying your loan.
Investing vs prepayment
Investing
Pros:
- Higher Returns: Investing can offer higher returns compared to the interest rates on your debt, especially if you invest in stocks or mutual funds over the long term.
- Compounding Interest: Your investment earnings can generate their earnings over time, potentially increasing your wealth significantly.
- Tax Benefits: Some investments, like retirement accounts, offer tax advantages that can enhance your returns.
Cons:
- Market Risk: Investments can be volatile and lose value, especially in the short term. There’s no guarantee of returns, unlike the guaranteed ‘return’ of saving on loan interest.
- Complexity: Investing wisely requires research and ongoing management, which can be daunting for some.
Loan Prepayment
Pros:
- Peace of Mind: Paying off debt, especially high-interest loans, can provide a sense of financial freedom and reduce stress.
- Guaranteed Return: Eliminating debt guarantees a return on your money equal to the loan’s interest rate. If your loan has a 5% interest rate, every dollar you pay toward the principal saves you 5% in future interest.
- Improved Credit Score: Reducing your debt can improve your credit score by lowering your credit utilization ratio, which can be beneficial for future borrowing.
Cons:
- Less Liquidity: Using extra cash to pay off debt means you’ll have less money available for emergencies or other investment opportunities.
- Opportunity Cost: You might miss out on higher returns from potential investments, especially if your loans have low-interest rates.
Investing vs Prepayment: Case Study
When securing a home loan, we carefully align our choice of monthly payments with our current financial landscape. Yet, as our earnings evolve, we’re often greeted with a compelling crossroads: the decision to either expedite the journey to becoming mortgage-free by prepaying our home loan or to potentially amplify our wealth through investing in mutual funds.
Ramesh has completed his Btech degree from a known engineering college, and after 10 years of work life in Mumbai, he decided to buy a house. With the high cost of houses in Mumbai, he had but one choice which was to get a home loan. But as he grew older, his salary increased and now he is in a dilemma – whether to prepay his loan or invest the extra money. Ramesh had been paying an EMI of Rs 1,16,300 on his loan of 1.5 cr for 20 years.
Scenario 1: Increase in EMI
After 3 years, Ramesh got a promotion and his salary increased. So he decided to increase his EMI by Rs 50,000 so as to decrease his tenure. Now he has to pay Rs 1,66,300 each month.
INCREASED EMI | |
Total loan | Rs 1.5 crore |
Total amount to be paid back in 20 years | Rs 2.8 crore |
EMI amount | Rs 1.16 lakh |
Amount paid in 36 months | Rs 41.9 lakh |
Opening balance on 4th year | Rs 1.38 crore |
Tenure decreased (after 3 years) | 115 months |
New EMI amount | Rs 1.66 lakh |
Amount to be paid to Bank in 115 months | Rs 1.91 crore |
Total Amount Paid in 13 years (Approx) | Rs 2.33 crore |
Total Interest Amount Saved | Rs 46 lakh |
Therefore, Ramesh saves Rs 46 lakhs on increasing his EMI.
Loss of tax benefits
Under income tax regulations, Ramesh is eligible for a tax deduction of up to Rs 1.5 lakh on the principal repayment annually under Section 80C. Moreover, he can claim a deduction up to Rs 2 lakh for the interest paid on the home loan each year under Section 24.
However, by choosing to repay his loan prematurely, he will miss out on these tax benefits. Although Section 80C provides various avenues for tax savings, Section 24 benefits are exclusive to the interest component of home loans. Thus, it’s assumed that Ramesh will relinquish the advantages offered by Section 24.
Tax Benefits Lost | |
Tax bracket | 30% |
Tenure (approx) | 7 |
Tax Saving he won’t be able to claim | Rs 10.5 lakh |
Returns if EMI diverted to SIP after early closure
Imagine that, once his home loan is fully repaid, he opts to channel the funds previously allocated for his home loan EMI into mutual funds via SIPs (Systematic Investment Plans). We’ll explore the potential size of the investment corpus he could build over the next seven years.
SIP Investments | |
Amount Invested per month | Rs 1.66 lakh |
Tenure(months) | 89 months |
Average Annual Returns | 12% |
Total Corpus at the end | Rs 2.39 crore |
Return | Rs 91 lakh |
So he gets a return of Rs 91 lakhs.
Total Benefit/Gain if he closes the loan early
Now, by adding the investment returns, the amount saved on interest by settling the loan early, and subtracting the forfeited tax advantages, his total financial benefit from closing the loan ahead of schedule amounts to Rs 1.27 crore.
Total Gains | |
Return by SIP | Rs 91 lakh |
Amount saved as home loan interest rate | Rs 46 lakh |
Tax benefit lost | Rs 10.5 lakh |
Total gains | Rs 1.27 crore |
Scenario 2: Invest
Let’s imagine Ramesh decides to maintain the agreed upon EMI for the entire loan term, but starting in the fourth year, he plans to invest an extra amount, say Rs 50,000, instead of increasing his EMI payments. We will now assess the size of the investment fund he could potentially accumulate following this approach.
SIP Investments | |
Amount Invested per month | Rs 50,000 |
Tenure(months) | 204 months |
Average Annual Returns | 12% |
Total Corpus at the end | Rs 3.34 crore |
Return | Rs 2.32 crore |
By allocating Rs 50,000 towards investments for 17 years, he’ll build a fund worth Rs 3.34 crore, with the earned returns amounting to Rs 2.32 crore.
In this scenario, he will also retain his eligibility for tax deductions throughout the 20-year loan period. Let’s explore the additional tax savings he would accrue during the extended 7 years of his loan’s lifespan.
Tax Benefits Lost | |
Tax bracket | 30% |
Total additional interest he will be paying | Rs 46 lakh |
Additional Tax Saving under Section 24 | Rs 10.5 lakh |
Total Benefit/Gain
Now, by adding together the investment returns and the extra tax savings, then subtracting the additional interest payments made to the bank, he will net around Rs. 1.96 crore.
Total Gains | |
Return by SIP | Rs 2.32 crore |
Total amount of taxes saved | Rs 10.5 lakh |
Extra interest you pay for the home loan | Rs 46 lakhs |
Total gains | Rs 1.96 crore |
The Final Verdict
From the calculations presented, if Pranay opts to settle his loan earlier, he stands to gain Rs. 1.27 crore. On the other hand, choosing to invest could elevate his total earnings to Rs 1.96 crore.
This significant difference stems from two key factors:
- Mutual funds, particularly equity mutual funds, have the potential to yield higher returns over the long term compared to the interest charges on a home loan, even though their returns aren’t guaranteed.
- The real benefits become evident only after accounting for tax savings. Especially for those in higher tax brackets, the savings from tax deductions can be substantial.
Nonetheless, it’s crucial to note that these outcomes are contingent on consistently investing and scaling up investments in line with salary increments. Misallocating additional income towards lifestyle upgrades instead could jeopardize this financial strategy.
Making the Decision: Invest or Prepay?
The decision to invest or prepay your loan depends on several factors, including the interest rate of your loan, the expected return on your investment, your financial goals, and your risk tolerance.
Generally, if the expected return on investment is higher than the loan’s interest rate, investing might be the more lucrative option. However, paying down debt offers a guaranteed return in the form of interest savings, which is particularly appealing if you’re risk-averse or prioritizing financial stability.
Conclusion: Charting Your Financial Path
Deciding whether to prepay loans or invest extra cash isn’t a one-size-fits-all answer. It depends on your financial situation, the interest rates involved, and your personal goals. Consider the pros and cons of each option, and think about what makes the most sense for you and your financial future. Sometimes, a balanced approach of doing a bit of both can also be a smart strategy. No matter what you decide, taking action with your extra cash is a step in the right direction toward financial health.
Before making any decisions, it might also be helpful to consult with a financial advisor to get personalized advice based on your specific circumstances. Remember, the best choice is one that aligns with your financial goals and gives you peace of mind.
Still confused? Get in touch with our team of Credit Dharma Experts!
FAQs
Not necessarily. Consider your risk tolerance and financial stability. Investments carry risk, whereas loan prepayment offers a guaranteed return by saving on interest.
By providing a side-by-side comparison of investing versus loan prepayment, this calculator enables users to visually and quantitatively assess which option might lead to better financial outcomes based on their specific circumstances. It helps in strategizing long-term financial goals, taking into account the impact of compound interest, investment growth, and debt reduction.