Should You Prepay Your Home Loan?

For most of us when we retire, our home will be our largest asset. It will also be closest to our heart as we will have fond memories attached to it. Often there is a question that we face whether to prepay our home loan or invest that money instead. In this post we want you to consider the following aspects of home loan that will decide whether you should prepay your home loan or invest that money somewhere else:

Home Loan – A Burden?

Most of us think of home loan as a burden. We urge you to think differently. We urge you to think of your finances like how a company would. Before we look at the question of the home loan prepayment, there is a simple yet elegant concept that we need to understand.

If the returns on capital employed is greater than the cost of capital, we are in a profitable investment.

What does this mean, in the context of the home loan question? Simple, if one can invest the money allocated to home loan prepayment into an asset that gives a return greater than the home loan interest rate, we are better off not prepaying the home loan. For instance, if mutual funds return 12% and your home loan interest rate is 9.5%, investing in the mutual fund will be better than prepaying your home loan. It’s all about the numbers.

Tax Benefits

The home loan brings us some attractive tax benefits on the principal and interest repayment. So effective interest rate that you pay for the home loan is lesser after claiming tax benefits.

Interest of up to 2 lakh is tax exempt for a self-occupied house and is uncapped for a let-out property (of course income from rent needs to be adjusted). So if you prepay your home loan, the tax benefits will reduce unless the interest component that you currently pay is much over 2 lakhs. Take this into account when you make the decision.

Household Cash Flow

Again, we need to think how an organization would treat its finances for growth. Even if the rate of return is greater than the home loan rate, we need to worry about cash flow.

That is, the home loan EMI should be comfortable for us to maintain a reasonable savings rate. There is no point in borrowing a large sum, and then struggling for money at the end of the month. In such cases, it is wise to prepay part of the home loan and reduce EMI/term to what is comfortable for us.

Term Reduction vs. EMI Reduction

The banks are cunning. When you try to prepay your principal, the bank may offer to reduce your EMI rather than the duration/term. This is not beneficial unless you are struggling with the monthly outgo.

It is always advisable to reduce term first so that your house gets paid off as quickly as possible. The banks always try to milk the maximum out of you, so be aware.

Eligibility for Other Loans

In the rarest of rare cases, you may wish to take a loan for another purpose in the future. By prepaying your home loan, you increase your future loan eligibility. But at the same time you are just changing hats not really gaining anything in the process.

Sentimental Reasons

To prepay or not to prepay a home loan is also a sentimental issue. Prepaying a home loan brings security, a sense of ownership and achievement. We respect that. In the end, we live to be happy and healthy. Do consider your happiness and peace of mind when you make the final decision.

Take all the above factors into account before you make the decision of prepaying your home loan.

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.