Deciding whether to invest extra funds or use them to prepay your home loan is a common dilemma for homeowners. It’s all about weighing the potential returns from investing against the benefits of reducing your mortgage debt.
If you’re facing this choice, this guide is here to help. Whether you’re inclined to invest or focus on prepaying your loan, we’ll break down both options so you can confidently choose the path that best fits your financial goals. Keep reading to gain clarity and make a decision that works for you.
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Understanding the Basics
Pros and Cons of Investing
| Pros and Cons of Investing | Details |
|---|---|
| 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. |
| 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 and Cons of Prepaying Home Loan
| Pros and Cons of Prepaying Home Loan | Details |
|---|---|
| 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. |
| 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. |
Investment Vs Prepayment Calulator
A Detailed Case Study: Investing or Prepaying Home Loan
General Context of the Study
Mrs. Kavita, a working professional, is in a bit of a dilemma about what to do with the bonus she’s just received. She’s torn between two options: putting the extra money towards paying off her home loan faster or investing it elsewhere. It’s a big decision that could impact her financial future and overall peace of mind.
Let’s break it down and help her figure out the best choice for her situation.
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.
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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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.
Frequently Asked Questions
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.
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.
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.
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