Thursday, October 8, 2015

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.

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