Making financial decisions about whether to invest surplus funds or use them to prepay a home loan is a common challenge for homeowners. The dilemma revolves around the choice between potentially earning more through investments or reducing long-term debt by prepaying the home loan.
If you find yourself in a similar situation, grappling with the question of what to do with your extra funds, this article is personalized to help you navigate through the complexity.
Whether you lean towards investing or prepaying your home loan, the information presented here will guide you through the intricacies of each scenario, helping you make a decision that aligns with your unique financial goals and circumstances.
Continue reading to understand the detailed situation and equip yourself with the knowledge needed to make a more confident and effective financial choice.
Understanding the Basics of Investing/ Prepaying Home Loan
Pros of Investing
- Potential for higher returns: Investments in stocks, bonds, or mutual funds can offer significant returns over time.
- Diversification: Investing allows you to spread your risk across different assets, reducing the impact of a single investment’s poor performance.
Cons of Investing
- Market risks: Investments are subject to market fluctuations, and there’s always the potential for loss.
- No guaranteed returns: Unlike prepaying a home loan, investment returns are not assured.
Pros of Prepaying Home Loan
- Interest savings: prepaying your home loan reduces the outstanding principal, resulting in interest savings over the loan tenure.
- Guaranteed return: The interest saved is a guaranteed return on your money.
Cons of Prepaying a Home Loan
- Opportunity cost: The funds used for prepayment could potentially have earned higher returns through investments.
- Liquidity reduction: prepaying ties up funds that could be needed for emergencies.
A Detailed Case Study: Investing or Prepaying Home Loan
General Context of the Study
Mrs. Kavita, a working professional, currently finds herself in a dilemma, unable to decide how to utilize the extra money she has received as a bonus from her company. Faced with two options, she must choose between accelerating her home loan repayment or investing the surplus funds. This decision is crucial for her financial well-being and peace of mind.
To determine the best course of action, let’s analyze the details to help Kavita make an informed and confident decision for her financial future.
Scenario 1: Kavita Chooses to Accelerate Loan Repayment
Kavita decides to expedite her home loan repayment by increasing the EMI to Rs. 1.2 lakh per month for the next 12 years.
Let’s analyze the financial details:
Reduced Tenure Analysis
Details | Amount (INR) |
Original Loan Amount | 1.5 crore |
Total Amount to be paid in 25 years | 3.6 crore |
Initial EMI | 95,000 |
Total paid in 48 months | 45.6 lakh |
Principal Amount at the end of 4th year | 1.35 crore |
Reduced Tenure (after 4 years) | 12 years |
New EMI amount | 1.2 lakh |
Amount paid in 12 years | 1.73 crore |
Total paid in 16 years | 2.19 crore |
Interest Amount Saved | 1.41 crore |
Loss of Tax Benefits due to Early Repayment
Details | Amount (in INR) |
Tax Bracket | 25% |
Tenure | 8 years |
Forgone Tax Benefit | 15.75 lakh |
Additional Returns if EMI Diverted to SIP after Early Closure
Details | Amount (in INR) |
SIP investment per month | 1.2 lakh |
Tenure | 8 years |
Average annual returns | 10% |
Total Corpus after 8 year | 1.5 crore |
Returns earned | 60.6 lakh |
Total Benefit/Gain from Early Closure
Details | Amount (in INR) |
Returns Earned | 60,60,000 |
Interest Amount Saved | 1,41,00,000 |
Tax Benefit Foregone | -15,75,000 |
Total Gains | 86,35,000 |
Scenario 2: She Chooses to Invest Surplus Amount
Now, Kavita has decided to maintain the original EMI but invest the surplus ?45,000 from the fourth year. Let’s evaluate the outcome:
Investment Analysis
Details | Amount (in INR) |
SIP investment per month | 45,000 |
Tenure | 21 years |
Average annual returns | 12% |
Total Corpus after 8 years | 3.2 crore |
Returns earned | 2.35 crore |
Additional Tax Benefit if She Sticks to Original Tenure
Details | Amount (in INR) |
Tax bracket considered | 25% |
Additional interest paid in 12 years | 1.41 crore |
Additional Tax Saving under Section 24 | 15.75 lakh |
Total Benefit/Gain by Continuing the Loan
Details | Amount (in INR) |
Returns earned by investing | 1.2 lakh |
Total taxes saved in the last 12 years | 10% |
Extra interest paid for the home loan | -1.41 crore |
Total Gains | 2.09 crore |
The Verdict: Continuing the Home Loan and Investing Extra Amount is a Better Option
In this altered scenario, choosing to invest the surplus amount rather than closing the loan early results in a higher gain of Rs. 2.09 crore compared to the gain of Rs. 86.35 lakhs from early closure. This emphasizes the significance of carefully considering both investment returns and tax implications in making informed financial decisions.
Key Takeaways of the Analysis at a Glance
Factors | Investment Perspective | Prepayment Perspective |
Higher returns | The investment scenario yielded a profit of ?2.09 crore after twelve years. | Guaranteed return: Kavita secured a guaranteed return through interest savings. |
Flexibility | Kavita has liquidity and can access the invested amount if needed. | Reducing debt can provide financial peace of mind. |
Market risks | If the Indian market had performed poorly, Kavita could have faced losses. | The foregone investment returns could have been higher. |
Considering Investments vs. Home Loan Prepayment: What You Must Do?
When faced with surplus funds, homeowners often contemplate whether to invest the money or use it to prepay their home loan.
You must consider the following aspects:
- Interest Rates on Investments: If the potential returns from your investments are expected to be higher than the interest rate on your home loan, it may be more logical to invest the surplus funds, capitalizing on higher investment returns.
- Tax Benefits: Evaluate tax implications, considering benefits associated with both home loan repayment and certain investments. Some investments offer tax advantages that can enhance overall returns, making them more attractive than prepaying a home loan.
- Diversification: Diversify your portfolio as a fundamental principle of investment. Instead of concentrating all resources on repaying a home loan, spreading risk through investments can potentially yield better long-term results.
- Emergency Fund and Liquidity: Maintain an adequate emergency fund before allocating funds to either prepaying a home loan or investing. Liquidity is crucial for unforeseen expenses and financial security.
- Financial Goals: Align your investment decisions with your financial goals. If long-term wealth creation is a priority, investing may align better; however, if debt reduction and financial security are paramount, prepaying the home loan may be the preferred option.
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What happens when you apply for a home loan with Credit Dharma?
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Simplifying Home Loans with Credit Dharma
With Credit Dharma, you can optimize your savings on home loans, attain quicker loan freedom, and benefit from a one-stop solution for all your housing finance needs.
- Competitive Home Loan Interest Rates: Enjoy the advantage of low-interest rates starting at 8.4% p.a., helping you reduce the overall cost of your Home Loan.
- Swift Loan Disbursal: Experience faster loan disbursal, ensuring you can proceed with your home plans without unnecessary delays.
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You can check out Credit Dharma’s home loan eligibility calculator to determine the loan amount you qualify for based on your income.
Here is a table summarizing the top home loan bank partners with their respective interest rates and maximum tenures:
Bank Partner | Interest Rate Range | Maximum Tenure |
SBI Home Loan | From 8.40% p.a. | Up to 30 years |
BOI | From 8.45% p.a. | Up to 30 years |
Bajaj Finance | From 8.45% p.a. | Up to 40 years** |
Kotak Mahindra Bank | From 8.75% p.a. | Up to 20 years |
LIC HFL | From 8.45% p.a. | Up to 30 years |
HDFC Home Loan | From 8.45% p.a.* | Up to 30 years |
Axis Bank | From 9.00% p.a. | Up to 30 years |
ICICI Bank | 8.40% – 9.45% | Up to 30 years |
L&T Finance | From 8.60% p.a. | Up to 25 years |
PNB | From 8.50% p.a. | Up to 30 years |
Conclusion
The decision to invest or prepay a home loan depends on individual risk tolerance and financial goals. Investors seeking higher returns may opt for investments, while those prioritizing guaranteed returns and reduced debt may prefer prepayment.
A balanced approach, such as allocating a portion to investments and the rest to debt reduction, may suit some individuals. In the end, you must consider individual circumstances, risk appetite, and long-term financial objectives when making this decision. To consult with a financial advisor you can schedule a demo with the Credit Dharma expert team.
FAQs
Why should I consider prepaying my home loan?
Prepaying your home loan reduces the outstanding principal, resulting in interest savings over the loan tenure. It provides a guaranteed return and helps in reducing long-term debt.
Are there risks associated with investing compared to prepayment?
Yes, investing comes with market risks. If the market performs poorly, you could face losses. prepayment, on the other hand, provides a guaranteed return but foregoes the potential for higher returns from investments.
Should I review my decision periodically?
Yes, it’s advisable to review your financial situation periodically and adjust your strategy based on changing goals, market conditions, and personal circumstances. Regular reviews with a financial advisor can help ensure your approach remains aligned with your objectives.