If you have an outstanding home loan, and happen to have just received an annual bonus or any other lump sum payment, should you use it to prepay your loan? Or, should you invest it to meet some other goals? Assess the following conditions to arrive at the right decision.
The first variable to be considered is psyche: some people may not be comfortable with a large housing loan and to reduce their stress they may want to get rid of the loan burden at the earliest. For them, settling the question of how to use their bonus is simple: just pay off the loan. Gaurav Mashruwala, Sebi-registered investment adviser, categorically states: “You should pay off the home loan at the earliest. Several unfortunate happenings— job loss, death of the earning member, serious illness, etc—can cause trouble during the 10-15 year loan period. Treat it as a mind game and not a numbers game.”
Tax benefit is the next variable. If a home loan does not seem like the sword of Damocles hanging over your head, it makes sense to continue with the regular EMI schedule. This is because of the tax benefits that a home loan offers. The principal component of the EMI is treated as investment under Section 80C. The interest component is also deducted from your taxable income under Section 24. The annual deduction in respect of the interest component of a housing loan, for a self occupied house, is limited to Rs 2 lakh per annum.
You won’t be able to claim deduction on interest paid above Rs 2 lakh. So, if your annual interest outgo is higher than Rs 2 lakh, it makes sense to prepay the loan, and save on future interest payment. For example, the annual interest on a Rs 70 lakh outstanding loan, at 9.5%, comes out to be Rs 6.65 lakh. After taking into account the Rs 2 lakh deduction under Section 24C, the interest component will fall to Rs 4.65 lakh, and bring down the effective cost of interest from 9.5% to 8.64%, even for the people in the 30% tax bracket.
You can, however, optimize the tax benefits if the loan has been taken jointly, say, with your spouse. “If joint holders share the EMIs, both can claim Rs 2 lakh each in interest deduction,” says Harsh Roongta, Sebi-registered investment adviser. In case of joint holders, there is no need to prepay if the outstanding amount is less than Rs 40 lakh.
There is no cap on deduction in lieu of interest paid on home loan, if the property is not self-occupied. “Since there is no cap for interest on loan against second or rented out homes, there is no need to prepay it,” says Naveen Kukreja, CEO and Co-founder, Paisa Bazaar. Bear in mind, by prepaying your loan, you may also forego future tax benefits. For instance, if by prepayment, you bring down your outstanding loan amount to Rs 20 lakh, your annual interest outgo for subsequent years may fall below Rs 2 lakh. Thus, you won’t be able to avail of the entire tax-deductible limit and, in such a scenario; prepayment may not be a good strategy. Also, building an emergency fund, if you don’t have one, should take a priority over prepaying the housing loan: “Make sure that you have a contingency fund in place before opt for prepaying your home loan.
The third key variable is returns from investment of the lump sum at hand. As a thumb rule, you should go for investment, instead of prepayment, only when the post-tax return from the investment is likely to be higher than the effective cost of the housing loan. For investors in the 30% tax bracket, and whose outstanding home loan balance is less than Rs 20 lakh, the effective cost of loan is only 6.65%. Since there are several risk-free, tax-free debt options such as PPF, Sukanya Samruddhi Yojana and listed tax-free bonds, which offer higher annualized return than this, it makes sense to invest in them.
All the debt products mentioned above are long-duration products. If your risk-taking ability is higher and time horizon is longer, you can consider investing in equities, which can generate better returns “It’s sensible for long-term investors (five year-plus holding period) to go for equities, provided they are savvy and understand the risks involved there,” says Kukreja.
There are some home loan products that provide an overdraft facility of sorts and help you maintain liquidity. All you have to do is to park the surplus money in these products and not bother with whether it’s a prepayment or not. It’s like prepayment with the option of taking out that money, in case you need it in future for personal use or for investment purpose. The strategy of maintaining the housing loan interest close to Rs 2 lakh per annum can also be managed by these special loan products. And even if you are going to invest, the SIPs can go from this account.
“I park my bonus and do SIPs in equity from the loan account,” says Kukreja. Most banks charge more for these special loan products. “Though the stack rate differential is more, you can bring it down by bargaining with the banks.