Should we repay our home credit or contribute all things being equal?

Does repaying your loan earlier always make sense? Or should you instead invest? Let’s find out.

Home loans are tricky. We chase them when we want to buy a house. Once, however, the initial excitement of purchasing a home dies down and the city commute picks up, attention is diverted to the enormity of the monthly repayment or loan EMI.

It’s rare to find a homeowner who has bought the property outright without a loan and it’s also rare to find one who isn’t keen on getting rid of the loan as soon as possible.

Home loans present you with a solution but with strings attached. Here is why.

A home loan taken at 8% per annum for a 20-year tenure is likely to have an aggregate interest cost of slightly over 50% of the amount you repay if you hold on to the loan for the entire tenure.

Home loan rates today are at 6.75% a year to 7.15% a year. However, your older home loans will still be at 8% or higher annual interest.

The numbers work like this

Say you take a home loan of Rs 1 cr at 8% interest a year for a period of 20 years, the EMI works out to roughly Rs 83,640 a month. This, in 20 years, translates to an aggregate payment of just over Rs 2 cr.

You are repaying double of what you took on as a loan, hence, interest cost is half of what you pay.

To avoid this outcome, you may want to repay the loan before it completes the entire tenure. However, don’t be too quick to resolve this situation via pre-payment of your home loan. There are a few things you need to weigh in.

What’s the remaining tenure?

Home loan EMI is structured in a way that is relatively more beneficial to the bank rather than for the borrower.

The EMI amount remains constant every year, in the first 10-11 years of the repayment schedule. The principal repayment, though, is much lower as compared to the second half of the tenure.

If you are keen to repay, the maximum benefit lies in repaying in the first 5-7 years as you will save a lot.

If it’s the latter half of your tenure, you have already paid around 70% of the interest cost by year 10-11 (at an interest rate of 8% per annum) and would be saving very little.

Money is fungible. If your home loan interest rate is low, instead of focusing on late pre-payment, use that money to invest for the same number of years as remaining in your EMI.

Choose an investment option that can earn you a return higher than the home loan interest rate. For example, over a period of 9-10 years, equity mutual funds can potentially deliver inflation plus returns higher than your home loan rate, thus, putting your money to work instead of a simple repayment.

Are you saving to repay or is it a lump sum?

If having a big loan makes you uncomfortable and you are cutting corners on other expenses, saving up for pre-payment may be an emotional need rather than a logical one. In such a situation, you should do as the heart desires.

If on the other hand you inherit a lump sum or get some windfall gains or bonus and are comfortable around daily cash flow, you may have to rethink pre-payment.

Once again, you can put the lump sum money to work with efficient investments that earn more than what you are paying for the home loan.

As long as you can leave that money invested for a long period matching your remaining tenure, you can take advantage of the higher return from market-linked investments.

This can be structured such that risk is limited but return tops the loan interest cost. For home loans at above 10% interest per annum, it may be suitable to pre-pay regardless as the cost is very high.

Takeaway

Repaying your home loan before time seems intuitive, however, lump sums can often be better utilised through efficient investing. Make sure that the EMI is not interfering with monthly cash flow requirements and lifestyle expenses before choosing to invest over pre-payment.

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