Investment v/s Home Loan pre-payment

Investment v/s Home Loan pre-payment

Owning a home of yours is indeed a good feeling but in today’s world, it is invariably accompanied with the burden of a housing loan. The question that bothers borrowers is that should they receive an annual bonus or a lump sum amount from some source, whether it should be invested in other instruments or be used to pay off that huge outstanding due. Here is an attempt to enlighten you on some pointers that may help you make that crucial decision.

The first condition is to understand your psyche. For some, settling the question of how to use the bonus is simple – repay the home loan. These people do not wish to reel under the stress of a large outstanding in their name.

Gaurav Mashruwala, Sebi-registered investment adviser opines that the home loan should be paid off at the earliest. Any inopportune events like job loss, death of the earning member, serious illness, etc can cause trouble during the 10-25 year long loan tenure. Clearing a big chunk of dues should be treated as a mind game and not considered as mere numbers.

The next variable is the tax component. If your psyche allows you to not think of that home loan as a sword hanging over your head, continuing with the regular EMIs may be the wiser option. This is because of the tax benefits that a home loan offers. While the principal component of the EMI is treated as investment under Section 80C, the interest component is deductable under Section 24 from your taxable income.

The annual deduction that can be claimed in respect of the interest component of a housing loan for a self occupied property is limited to Rs 2 lakh per annum.  Therefore, you won’t be able to claim deduction on interest paid above this cap. So, if your annual interest outgo is higher than Rs 2 lakh, it makes more sense to prepay the loan, and save on future interest payment.

For instance, the annual interest on an Rs 70 lakh outstanding loan at 9.5%, works out to Rs 6.65 lakh. After considering the Rs 2 lakh deduction under Section 24C, the interest component will reduce to Rs 4.65 lakh bringing down the effective cost of interest from 9.5% to 8.64%, including those in the 30% tax bracket.  The tax benefits can be further optimized if the loan has been taken jointly. “If joint holders share the EMIs, both can claim Rs 2 lakh each in interest deduction,” advises Harsh Roongta, Sebi-registered investment adviser. In case of joint holders, prepayment may not be required if the outstanding amount is less than Rs 40 lakh.

Further, since there is no limit for interest on loan against second or rented out homes, there is no need to prepay the loan either. One should also bear in mind that with pre-payment of the loan, you may miss out on future tax benefits. For example, after prepayment, outstanding loan amount comes down to Rs 20 lakh; your annual interest outgo for subsequent years may fall below Rs 2 lakh. Here, pre-payment is not a prudent strategy as you won’t be able to avail of the entire tax-deductible limit.

The third important aspect during decision making in this regard is returns from investment of the lump sum available with you. You should opt for investment instead of prepayment only when the post-tax return from the investment is expected to be higher than the effective cost of the home loan.

For those falling in the 30% tax bracket and having outstanding home loan balance is less than Rs 20 lakh, the effective cost of loan is merely 6.65%. Since there are several risk-free, tax-free debt options like PPF, Sukanya Samruddhi Yojana and other listed tax-free  bonds offering higher annualised return than this, it is advisable to invest in them rather than pre-paying the loan. If your risk-taking ability is higher and you are market savvy, you may also consider investing in equities where the return on investment is also higher.

You may also consider home loan products that provide an overdraft facility or a home loan bundled with a current account. This will help you maintain liquidity also. All you have to do is to park the surplus money in these products. It’s like prepayment with the option of withdrawing it in times of need, either 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 with these special loan products.