FLUSH with FUNDS? Prepay Home Loan or Invest the Surplus?

In this article, I intend to cover one of the most common dilemmas that individuals face with respect to their home loans; “Prepay or Invest?”

Through this post we wish to highlight some of the key factors that will help you arrive at a sound decision. While it is true that a Home Loan (or any other loan for that matter) irrespective of the quantum, is a psychological burden that one wouldn’t want to be living with for a lifetime, it would definitely serve us well to consider some of the Tax Benefits and Subsidies that a Home Loan in particular offers to individuals.

Let’s understand this with the help of a Case:

In her recently concluded performance appraisal, Shravani, a 30-year-old, salaried employee working at ABCD Corporation Ltd. qualified for a hefty performance linked bonus, likely to be credited soon to her account. Shravani’s income falls in the highest tax bracket of 30% (but short of the threshold beyond which surcharge is levied). She has a home loan outstanding of Rs.29,50,000/- as on date and a balance tenure of 25 years. She is servicing her loan at an Interest Rate of 7% p.a. (Annual Percentage Rate - APR). She has no other liabilities and is financially well off.

Ever since the bonus was announced, Shravani has been contemplating hard on the best possible avenues to deploy this surplus. Whether Prepaying the Home Loan or Investing the Surplus makes more sense, is what she has been primarily trying to figure out.

Let’s help Shravani make an informed choice.

With the information given above, one can compute the Equated Monthly Installments (EMI), and how the EMI amount gets split over principal and Interest.

Using the relevant TVM functions in EXCEL, this is the output we get:

Exhibit-1:

1. EMI = Rs.20,850/- p.m. (Total Annual Payment = Rs.2,50,200/-)

2. Principal = Rs.3642/- p.m. (Total Annual Payment = Rs.43704/-)

3. Interest = Rs.17,208/- p.m. (Total Annual Payment = Rs.2,06,496/-)

Now Let’s understand the tax benefit that Shravani enjoys on this Home Loan:

But before we get to the actual computation, here’s a list of the various possible benefits that one can avail on a Home Loan and decide on the ones to be considered in this situation:

1. Deduction of Principal Paid u/s 80C (Limited to Rs.1,50,000/- Annually):

The 80C gap gets plugged automatically in most cases by way of several qualified expenses such as Life Insurance Premium, Children’s tuition Fees, EPF Contributions, Home Loan Principal etc. However, since the 80C space is already crowded with several instruments vying for a space, the limit gets exhausted quite easily. In such a scenario, considering Deduction of Home Loan Principal as an exclusive benefit u/s 80C, might present us with a somewhat misleading picture, as such a step need not necessarily result in accrual of any incremental benefit to the individual. Thus, despite Home Loan Principal being one of the popular deductions under 80C, in order to maintain a conservative approach, we are not considering it for the purpose of this case study.

2. Deduction of Interest Paid u/s 24B (Limited to Rs.2,00,000/- Annually):

Unlike section 80C where many different instruments crowd the limited space available, the benefit u/s 24B can be availed under one head only i.e. Interest Paid on Home Loan. Moreover, this is a benefit that can be availed by individuals without too many qualifying conditions. Thus under Home Loans, Section 24B happens to be the most widely availed benefit and hence would be apt for our computation.

3. Deduction of Interest Paid u/s 80EEA (Limited to Rs. 1,50,000/- Annually):

This benefit (available over and above the benefit u/s 24B) can be availed only subject to certain conditions being met such as the Year of Availing the Home Loan, Stamp Duty Value of the Property, Carpet Area of the Property, etc. Let’s say, the individual in question doesn’t qualify to avail this benefit.

4. Subsidy availed under PMAY (Pradhan Mantri Awas Yojana):

In order to avail this benefit, among the several qualifying conditions, the individual should meet the income criteria and must also not own any other residential property. For the purpose of this computation, Let’s assume, Shravani doesn’t qualify to avail this benefit.

Note: The above benefits are mutually exclusive and can be availed subject to the eligibility conditions being met for each. It is likely that a good number of individuals would benefit from one or two benefits but not all of them. Hence going by the rationale stated against each of the qualifying benefits, I will consider only Deduction u/s 24B. This will give us a conservative yet realistic estimate.

As per the computation, shown in Exhibit-1, Shravani pays an interest amount of Rs.2,06,496/- Annually. The maximum deduction on interest allowed annually u/s 24B is Rs.2,00,000/- and hence the eligible deduction will be capped at this limit. Since Shravani falls in the 30% tax bracket, the overall benefit here in terms of tax savings would be Rs.62,400/- (@ 30% tax rate on Rs.2,00,000/- plus 4% Cess, and assuming surcharge doesn’t apply)

Thus, the Net Interest Outgo for the Year = Interest Paid (Rs.) – Tax Savings on Interest Paid (Rs.)

= Rs.2,06,496 – Rs.62,400 = Rs.1,44,096/-

The Net Interest Outgo in the year as a percentage of the Outstanding Loan Amount = 4.88% (Approx.)

Thus, for Shravani, the Effective Cost of the Home Loan is approximately 4.88% p.a.

The question now is whether Shravani should foreclose the loan with an effective cost as low as this or continue servicing the loan at least for the time being, and deploy the surplus funds elsewhere?

To arrive at a conclusive decision, we need some more inputs on the choices available to us, if we were not to foreclose this loan. Not going for a Pre-payment / Foreclosure would leave Shravani with several investment options for deploying this surplus. Given below are some of the popular investment choices and the potential returns one can expect out of them:

Exhibit-2:

1. Bank FD => 3 – 4 % p.a. (Post Tax) for a person in the Highest Tax Slab

2. Liquid MF => 4 – 5 % p.a. (Post Tax)

3. Debt MF => 6 – 7 % p.a. (Post Tax)

4. Hybrid MF => 8 – 10% p.a. (Post Tax)

5. Equity MF => 10 – 12% p.a. (Post Tax)

6. Direct Equity => 12 – 14% p.a. (Post Tax)

Note: The above returns are just indicative in nature and may vary depending on the choice of instrument, variants within each instrument category, market conditions, etc.

Going by the indicative returns shown above, it becomes amply clear that the only instruments that can cover the Cost of Loan by a fairly handsome margin are Debt Funds, Hybrid MFs, Equity MFs and Direct Equity. Bank FDs fail to cover the cost, whereas Liquid funds just about match the cost of the Loan. However, the choice of instrument for any individual may not always be as straightforward as stated above. Rather, it will be determined by a series of critical factors such as the Nature of the Goal the individual wishes to achieve, the Time in Hand to achieve the Goal, the Significance of the Goal, and the Risk Appetite of the Individual. Once an individual has clarity on these aspects, the returns grid just makes the final decision a touch easier.

Conclusion:

While doing the math, I have considered only the most popularly availed deductions under the home loan category i.e. Deduction u/s 24B. For those eligible to avail some of the other benefits too, the cost of loan drops further, thereby making foreclosure or prepayment less and less attractive.

Thus, the prevailing low rates of interest, the tax benefits and other subsidies, all put together, leads to a significant drop in the overall cost of the loan. Moreover, with efficient instruments available that can fetch a rate of return much higher than the Cost of Loan, as shown in Exhibit-2 above, there’s hardly a case for Prepayment or Premature Closure of Home Loans in this situation.

Remember, the benefits of taxation keep diminishing as the loan amount gets higher, since the interest deduction is capped at Rs.2,00,000/- annually. Thus the excess interest paid over and above the capping doesn’t get any preferential tax treatment. Hence for High Value Loans, it would be prudent to make part pre-payments (especially during High Interest Periods) at periodic intervals to the point where the loan outstanding is just enough to optimize the tax benefits.

About the author

Deepak Rameshan, CERTIFIED FINANCIAL PLANNER^CM, Dip TD, MMS.

Deepak Rameshan is a CFP^CM professional, and has been working in the financial services domain for close to 13 years. He holds a Master’s Degree in Management Studies and a Diploma in Training & Development and has been actively engaged in Training & Content Development during this period. As a Personal Finance Enthusiast and an avid researcher of the subject, Deepak has delivered several Investor Awareness Workshops over the years covering areas such as Risk Planning & Insurance, Retirement & Goal planning, Tax Planning and a few other specialized areas. He takes keen interest in writing and has penned numerous articles for this blog, addressing some of the most relevant concerns that individuals face with respect to their finances.

“Financial Planning Standards Board Ltd. (FPSB Ltd.) is the proprietor of the CFP^CM, CERTIFIED FINANCIAL PLANNER^CM and marks outside the United States, including in India, and permits qualified individuals to use these marks to indicate that they have met FPSB Ltd.’s initial and ongoing certification requirements.”

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