Is home loan prepayment really beneficial ????

I keep on receiving lot of queries as whether one should continue to pay home loan or invest the surplus available.

It would be wrong if I only discuss financial aspect. Apart from financials, lot of other factors, which also needs to be considered.

Trying to cover most of it, with a word of caution and request to consult your financial advisor before taking decision. The right and timely decision can help to reap big benefits out of housing loan.

Request readers to go through complete article to understand benefits, assumptions and other aspect related to it.

1) Financial benefits : 

Lot of people claims that it is always beneficial to prepay housing loan, some claims it is advisable in earlier years as interest cost is very high.  

From financial benefit point of view IT IS ALWAYS BENEFICIAL TO INVEST THE SURPLUS AS COMPARED TO PREPAYMENT. Let me illustrate you with an example :

Lets assume following:

Case I - Prepayment :

Loan Amt.                                 : Rs.20,00,000

Tenure                                       : 20 Years

Interest                                      : 9.4% (SBI Present rate)

EMI                                            : Rs.18512/Month

Interest payment in 20 yrs.  : Rs.2442931

Capital Repayment in 20 yrs: Rs.2000000

Total Payment                          : Rs.4442931

Let's say you have surplus of Rs.500000 and you prepay so the total amount comes like this:

Interest payment in balance reduced term : Rs. 889323

Capital payment in balance reduced term  : Rs.1500000+500000 (Prepayment)

Total Payment                                                   : Rs.2889323

So the total benefit comes out to be Rs.1553608

Case II- Investing surplus without prepayment :

Let's say surplus amount of Rs.500000.00 is invested in tax free bond of PFC on offer right now @ 7.60% (Assuming annual interest is reinvested at same rate)

The maturity amount of Rs.500000 @7.60% after 20 years would become Rs.2163791

So the net gain by investing the same amount would be (Rs.2163791 - Rs.1679372) = Rs.484419.00. 

Benefit for interest repayment on housing loan during the term (considering 30% tax bracket) : 

2568680-889308 = Rs.1679372 @ 30% = Rs.503811

(Even,if we ignore tax benefit of 80C as in most of the cases it is covered by PPF,EPF and LIC Policies)

So the total benefit works out to be whoopping  (503811+484419) = Rs.988230.00

2) Inflation : Although it look very beneficial at first go, but after taking inflation @6% works out to be equivalent to Rs.3.08 Lacs in present terms. So if you are higher tax bracket benefit is considerable.

3) Assumption : We have assumed investment in tax free bonds which are right now available, But It won't be possible everytime to get such an avenue of tax free investment for 20 year long period. Together with it we have also assumed that the reinvestment of interest amount would also be at the similar rate.

4) TAXATION : As we are aware that there are 2 component to EMI first is Interest and other Capital repayment. 

As per section 24 your income shall be reduced by the amount of interest paid on Home Loan where the loan is taken by for Purchase/Construction/Repair/Renewal/Reconstruction of Residential House. The maximum deduction available for self occupied property is subject to a maximum of Rs.2 Lacs. In case it is not self occupied there is no upper ceiling.

In addition the amount paid as repayment of principal amount of home loan by individual/HUF is allowed as deduction under section 80C. This section also includes amount invested in PPF,EPF,ELSS scheme of Mutual Fund, NSC etc subject to total upper limit of Rs.1.50 Lacs.

So if you prepay your home loan, may be you loose tax benefit against interest part as the interest component would reduce considerably.

5) Funds Requirement : Never deep into your contingency or emergency fund in a hurry to prepay your home loan. You must keep atleast 3 to 6 months of expenses for contingency.

6) Prepay Costlier Debt First : Home loan is the cheapest loan available. So if you have other outstanding consumer, credit card or personal loan. Prepay them first.

7) Defensive investors : If you are a defensive investor then I would advise you to prepay your home loan for any surplus amount because mental peace and health is more important then financial benefit.

8) Retirement Planning : If you have not planned for your retirement yet and you are right now in your 30s or 40s consider investing in Equity mutual funds to build retirement kitty.It may give you much more benefits then shown in illustration. If I consider historical Equity returns of 17% then Rs.5.00 lacs may become almost Rs.1.20 CRORE

9) Nearing your retirement : If you are planning to retire soon, then it is advisable to prepay your housing loan so that you don't have any liability after retirement.

10) Planning to spend surplus : If you are planning to buy some white good or a gadget or a depreciating asset out of surplus then it is advisable to prepay your home loan without any of above consideration.

Please take decision of prepaying or investing the surplus after considering above factor. Remember every penny saved is penny earned.

Learn how RBI stabilizes Price, Economic Growth and Market

The Reserve Bank of India (RBI) is the monetary authority of the country. RBI sets the monetary policy with the objectives of price stability, economic growth and financial market stability. RBI uses its monetary tools for effective pass through of monetary policy. RBI sets its annual monetary policy for a fiscal year in April and then subjects the policy to reviews every quarter with mid quarter reviews held a month before the quarterly review.

RBI Policy tools 

The tools used by the RBI for its monetary policy are:

1. Repo Rate

2. CRR (Cash Reserve Ratio)

3. SLR (Statutory Liquidity Ratio)

4. OMO (Open Market Operations)

5. MSS (Market Stabilization Scheme)

1. Repo (7.25% as of June 2015)

The repo rate is the benchmark policy rate. The repo rate is the rate at which the RBI lends money to banks. The lending operation is done through an auction called the LAF (Liquidity Adjustment Facility) auction. This auction is done on a daily basis and banks wanting to borrow funds from the RBI at the repo rate have to bid for funds in the auction. RBI lends successful bidders funds at the repo rate. The LAF is a collateralized lending platform where banks have to pledge government bonds or treasury bills with the RBI for borrowing money.

A rise in repo rate increases cost of funds for banks while a fall in repo rate reduces cost of funds for banks.

Rates linked to repo rates are the Reverse Repo rate and the Marginal Standing Facility (MSF). The reverse repo rate is the rate at which RBI borrows money from banks in the LAF auction. Banks with excess liquidity lends funds to RBI by bidding for reverse repo in the LAF auction. RBI gives government bonds or treasury bills as collateral to the banks.

The reverse repo rate is set at 1% below the repo rate.

The MSF is an emergency window for funds for banks. The MSF is set at 1% above the repo rate and banks in need of emergency funds borrow from the MSF window by bidding for funds at the MSF rate. Banks pledge government securities or treasury bills to borrow funds under MSF window. Under the Marginal Standing Facility (MSF), banks avail funds from the RBI on overnight basis against their excess SLR holdings. They can also avail funds on overnight basis below the stipulated SLR up to two per cent of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of second preceding fortnight.

2. CRR (4% as of June 2015)

Banks have to keep a percentage of their NDTL (Net Demand and Time Liabilities) as CRR with the RBI. RBI sets the CRR rate to reflect its monetary stance. The CRR rate is set higher if RBI wants banks to keep more money as CRR and lower if RBI wants banks to keep less money as CRR. The more money kept as CRR the less money banks have to lend and less money kept as CRR the more money banks have to lend

3. SLR (21.5% as of June 2015)

SLR is the percentage of NDTL that banks have to invest in government bonds. RBI sets the SLR rate to reflect its monetary stance. The higher the SLR rate the more money the banks should invest in government bonds and the less money they have to lend. The lower the SLR the less money banks should invest in government bonds and the more money they have to lend.

4. OMO (Open Market Operations)

RBI buys and sells government bonds directly in the bond market or through bond purchase and sale auctions. RBI buying government bonds adds liquidity into the system while RBI selling government bonds sucks out liquidity from the system. The higher the liquidity the more money banks have to lend and the lower the liquidity the less money banks have to lend.

5. MSS 

MSS securities are special government securities and treasury bills that are used to suck out liquidity from the system. RBI sells MSS bonds through auctions to banks and other investors. The money paid for buying the MSS bonds by investors are then held by the RBI in a special account and does not come into the system. The act of issuing MSS securities is an act of sterilization of excess liquidity, when the liquidity is generated by excessive capital flows into the country.

How does MSS work? Take for example RBI buying USD 1 billion. RBI USD purchase would add around Rs 630 billion of liquidity into the system. RBI does not want this liquidity staying in the system and wants to take it away. RBI will ask the government to issue MSS bonds, which can either be treasury bills or dated government securities. Government will auction MSS bonds and the money collected from auctioning the MSS bonds will be kept in a separate MSS cash account, as the government cannot spend this money. Hence liquidity goes out of the system and stays out of the system until the MSS bonds mature or until the MSS cash balances are released through de-sequestering of the cash balances.