Prepaying your home loan or invest that money instead, what should you do? 5 points to note

It is highly likely that the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will maintain the policy repo rate at their upcoming meeting. The escalating conflict between Iran and Israel may lead to higher crude oil prices, posing inflationary risks, while economic growth remains stable. The current fixed repo rate of 6.5% in India has caused home loan rates to remain unchanged, creating a dilemma for borrowers on whether to prepay their loans or continue their investment strategies.

This dilemma arises because, over time, the interest paid on a long-term home loan can exceed the principal amount, resulting in a significant repayment at the end of the loan term. Prepayment is a highly effective method to reduce repayment significantly, resulting in a smaller repayment amount and a shorter loan duration. 

However, many ask the question of whether one should prepay their home loan or invest that money instead in mutual funds or fixed deposits. 

Here are a few points to note:

1. Tax implications

According to income tax regulations, Pranay is eligible to avail a tax deduction of up to Rs 1.5 lakh under Section 80C for the principal amount paid in a financial year. Additionally, he can claim up to Rs 2 lakh on the interest amount under Section 24 annually.

However, if he decides to repay his loan ahead of schedule, he will have to give up these tax benefits. While Section 80C offers various options for tax savings, Section 24 specifically caters to home loan interest components.In accordance with income tax regulations in India, individuals can take advantage of tax benefits by utilizing provisions such as Section 80C and Section 24 of the Income Tax Act. Section 80C allows taxpayers to claim a deduction of up to Rs 1.5 lakh for the principal amount repaid in a financial year, while Section 24 permits deductions of up to Rs 2 lakh on the interest paid annually. It is important to understand that opting to repay the loan before its tenure may result in forfeiting these tax benefits.

Section 80C provides various investment options for tax-saving purposes, whereas Section 24 focuses specifically on the interest component of a home loan. If your parents are currently benefiting from tax deductions under Section 80C for principal repayment and Section 24(b) for interest paid, any decision regarding early repayment of the home loan should take into account the potential tax implications. If the prepayment does not impact your parents' tax benefits, you could consider repaying a portion of the home loan. 

2. Loan prepayment vs taking another loan

Prior to making a decision, it is important to analyze both planned expenses and unforeseen emergencies that may arise in the future. Home loans usually offer lower interest rates, making them a cost-effective borrowing choice. Therefore, it is advisable to thoroughly evaluate your financial objectives and liquidity requirements before opting for early repayment of the home loan.

3. Benefits of prepayment  

Making prepayments on your loan is a smart financial strategy that speeds up the repayment process, ultimately reducing the overall loan term. By paying off your loan early, you can become debt-free sooner, giving you greater financial freedom and allowing you to save more of your monthly income. This proactive approach to managing your home loan significantly decreases your debt burden and improves your overall financial security. Prepayment not only provides peace of mind by ensuring timely payment of financial commitments but also brings you closer to achieving your financial objectives and dreams.

4. Investment choice

When considering whether to prepay a home loan, it is essential to analyze the potential returns of other investment options for your surplus funds. If alternative investment products are expected to yield higher returns in the long term, it may not be advisable to prepay a home loan with a lengthy tenure.

One option to consider is investing in bonds issued by Non-Banking Financial Companies (NBFCs). Another alternative, depending on your risk tolerance, is investing in equity through equity mutual funds for a minimum period of 7-10 years. Historically, equity funds have shown higher returns compared to home loan rates over such extended durations. This strategy is particularly relevant as home loan tenures typically extend beyond ten years in many cases. To make a well-informed decision, it is crucial to compare the post-tax rates or returns in both scenarios.

5. Prepayment or emergency funds

Paying off your home loan ahead of schedule can have a significant positive impact on your financial situation. One key benefit is that it opens up your monthly income, giving you the flexibility to allocate it towards alternative investment opportunities, savings for future goals, or improving your overall quality of life. It is important to approach prepayment strategically, ensuring it does not come at the expense of your overall financial health. Before making any decisions about prepaying your home loan, prioritise essential expenses and establish a strong emergency fund to protect your financial stability.