Home loans are the most common forms of loans provided by banks and NBFCs. These are long-term loans with lower interest rates as compared to personal loans or credit card loans. However, since the cost of purchasing a new house is quite huge, the loan value is often in lakhs of rupees and some in crores, the EMI thus takes a chunk of the borrower’s earnings each month.
In such scenarios, borrowers are often tempted to close the home loan as early as possible to become debt-free instead of using the same money to invest in mutual funds or other investment options that can increase their wealth in the long run.
Given below is a brief comparison of the two options (preparing the home loan or investing in mutual funds) that can guide the investors in making profitable decisions.
Factors to be considered while prepaying the home loan
Preparing a home loan is a long-term debt that is often taken for durations like 20 years or so. The huge outflow of home loan EMIs every month during such tenure can be cumbersome or a burden that can lead to prepaying the loan at the slightest windfall received by the borrower.
However, there are a few factors that have to be considered by the borrowers while prepaying the home loan. Some of these factors or pros and cons of prepaying a home loan are mentioned below.
- Reduced interest payment
One of the major incentives of closing or prepaying the home loan early is the reduction in the interest payments on the balance outstanding amount. Investors can significantly save the interest payment over the tenure of the loan through such prepayment.
- Mental peace of being debt free earlier than later
Most borrowers cannot relax till the time they complete their loan obligations and seek various ways to be done with them sooner than later. This is also one of the leading contributors in prepaying the home loan by the majority of borrowers.
- Penalty to be paid for prepayment of home loan
Prepayment of home loans is often subject to crew rules. Borrowers can prepay the home loan only a couple of times during the tenure of the loan and such payment is often restricted to a fixed percentage of the outstanding amount. Also, most banks and NBFCs charge a penalty for the prepayment of home loans (ones based on fixed rates). Such penalty is a percentage of the outstanding loan amount and is up to 4% or 5% approximately depending on the lender’s guidelines.
- Loss of tax benefits
Having a home loan provides tax benefits to the borrowers in the form of tax deductions of the principal and interest payment. Borrowers can claim a tax deduction of up to Rs. 1,50,000 under Section 80C for the principal payment as well as up to Rs 2,00,000 under Section 24 for the interest paid towards the home loan (actual interest paid in case of let-out property).
If the borrower chooses to prepay their home loan, they will lose out on these tax benefits. Such deductions significantly lower the tax liability especially for taxpayers in the mid or highest tax bracket. Hence, this makes it a valuable consideration before deciding to prepay the home loan.
Benefits of investing in mutual funds instead of prepaying the home loan
Mutual funds have been known to be a good contributor or investment option increasing the investor’s wealth over a period of time. The general rule of thumb is the longer the investment period, the higher the returns. Hence, they have attracted millions of investors over the decades.
Prepaying the home loan through any surplus funds may seem like a relief or reduction in debt for the borrower but let us compare it with the benefits of investing the same in mutual funds to see if which option is beneficial.
Liquidity is one of the prime benefits of investing in mutual funds. Investors can enter and exit the funds at any point in time depending on the market conditions to gain profits on their investments as well as maximize their returns. If the borrower will prepay home loans with the surplus amount, they may have their hands tied in case of any emergency but with mutual funds, they can simply liquidate their investment and use the funds for any emergency.
- Increased returns in the long term
Mutual funds, especially equity funds have time and again proved to be a better investment option than most options like bonds, FD’s, ETFs, etc. as they can beat the market average returns most of the time. Investors have the potential to gain maximum returns if they stay invested for longer durations (for example, a minimum of 5 to 7 years). This benefit will be lost if the surplus funds will be used to prepay the home loan.
- Availing tax benefits for the entire period of home loan
Paying the home loan EMI’s for the entire tenure of the loan may seem expensive or cumbersome but it outweighs the benefits received on account of tax savings. Borrowers can save significant tax liability by availing deductions on the loan payments. By adding these tax savings to the refunds received from mutual funds, the net benefit is higher as compared to simply prepaying the home loan.
When viewed by a layman, prepayment of a home loan seems to be a better option as it directly reduces their loan obligations and provides savings in interest payments. However, a person should make an objective comparison between prepaying the home loan or investing the surplus in mutual funds. This objective comparison will help them in understanding that investing in mutual funds will give them the dual benefit of good returns and increased capital as well as tax savings on EMI payments. This dual benefit significantly outweighs the benefits of simply reducing the home loan debt by increasing the wealth of the investors many times.
1. Can a borrower prepay the home loan at any time during the tenure of the loan?
A. Yes. Most lenders allow the borrowers to prepay their home loan after the initial period of 6 months from the sanction of the loan. Also, such prepayment is allowed only for a fixed number of times and up to a fixed percentage of the outstanding loan amount depending on the lender’s guidelines.
2 Do all mutual funds provide higher returns to the investors?
A. No. The performance of the mutual funds depends on many factors like prevailing market conditions, fund manager’s experience and expertise, assets invested by the fund, etc. Hence, not every mutual fund may provide good and consistent returns to its investors.
3. What is a foreclosure of a home loan?
A. Foreclosure of the home loans refers to the closing of the home loan account and paying or clearing all the outstanding dues to the lender before completion of the tenure of such loan.
4. What is a better option to invest in among equity funds or debt funds instead of prepaying the home loan?
A. Equity funds are a better option to invest in instead of prepaying the home loan as compared to debt funds. This is due to the fact that equity funds have traditionally outperformed debt funds in the long term. It is however to be united that equity funds are riskier than debt funds may not be ideal for risk-averse investors.
5. What is the biggest advantage of prepaying the home loan?
A. Home loan is a long-term debt that has a huge interest cost. Savings in this interest payment on account of prepayment of home loans are often considered as the biggest incentive or advantage for such prepayment