Should you prepay your home loan or invest instead?

It is the question every home loan borrower faces sooner or later. The bonus arrives, or a fixed deposit matures, or a relative repays a loan. You have a few lakh rupees, and two voices in your head. One says, “Pay down the loan and sleep better.” The other says, “The loan is cheap, invest it and earn more.”

Both voices can be right, depending on your situation. This guide gives you a plain way to decide, with a worked example so you can see what each choice does.

What prepaying really does

Interest on a home loan is charged on the balance you owe. Every rupee you prepay stops earning interest for the lender from that day, for the rest of the loan. That makes prepayment a guaranteed return equal to your loan’s interest rate. If your loan costs 9%, prepaying earns you a sure 9% a year. No market, no risk, no waiting.

Prepayment is allowed without charge on floating-rate home loans taken by individuals, under RBI rules. Fixed-rate loans may carry a charge, so ask your lender before you pay.

A worked example

Take a home loan with ₹20 lakh still to repay over 15 years, at an assumed 9% a year. The EMI is about ₹20,285. You receive ₹2,00,000 and use it to prepay, keeping the same EMI so the loan finishes sooner.

The same ₹2,00,000 saves about ₹3,80,834 more if you prepay at the start than if you wait ten years. That is because early EMIs are mostly interest, so early prepayment cuts the balance while it is earning the most. The sooner the money goes in, the more it saves.

You can also choose to lower the EMI instead and keep the tenure. In the same case, prepaying at the start and re-cutting the EMI brings it down to about ₹18,257 from ₹20,285. That helps your monthly cash flow, but it saves less interest than keeping the EMI the same and finishing earlier.

What investing can and can’t do

Investments such as equity mutual funds have, over long periods, often earned more than home loan rates. But “often” and “over long periods” are doing a lot of work in that sentence. Returns are never guaranteed. Markets can fall for years. And whatever you earn is usually taxed, while the saving from prepaying is not.

So the fair comparison is this: after tax and costs, will my investment earn more than my loan costs, every year, with certainty? If you can’t say yes to the last part, you are comparing a sure return with a hoped-for one.

Do these first, before either

1. 1Emergency fund. Keep several months of household costs plus EMIs in a safe, easy-to-reach place. Do not use this money to prepay. Once it goes into the loan, you can’t get it back when you need it.
2. 2Costlier debt. Clear credit card dues and personal loans first. They cost far more than a home loan, so each rupee saved there is worth more.
3. 3Insurance. Make sure you have adequate health and term life cover. A medical bill or an untimely loss can undo any plan.

A simple way to decide

• If your loan rate is high compared with what you can safely and surely earn, lean towards prepaying. You get a guaranteed return and a shorter loan.
• If your loan rate is low and you won’t need the investment money for many years, you can lean towards investing, with eyes open to the risk.
• If you are nervous about debt or close to retirement, lean towards prepaying. Being debt-free has a value that numbers don’t show.
• If you are unsure split the money. Put part into the loan and part into investments. You get progress on both and avoid regret either way.

The tax angle

In the old tax regime, home loan interest up to a limit of ₹2 lakh a year on a home you live in can be claimed as a deduction. When you prepay, you pay less interest, so the deduction shrinks too. If your yearly interest is well above the limit, prepaying costs you no tax benefit at all. If you are near or below it, factor it in. In the new regime, there is no such deduction for a home you live in, so prepaying has no tax downside. Check the current rules for your case.

How to prepay smartly

• Tell the lender whether you want to cut the tenure or the EMI. Unless cash flow is tight, cut the tenure.
• Prepay early in the loan, when it saves the most.
• Even small, regular extra payments, such as one extra EMI a year, can shorten the loan by years.
• Keep the receipt, and check the next statement to confirm the balance has dropped.
• Before you prepay a fixed-rate loan, ask about charges.

The bottom line

There is no single right answer, only the right answer for your rate, your risk appetite and your stage of life. A sure saving beats an uncertain gain when the amounts are equal. Cover your emergency fund and costlier debt first, then decide between the loan and the market, or split the money between them. If you are also thinking of moving your loan to a cheaper lender, see how a balance transfer works before you prepay.