Hello all, I have a home loan running and I have some extra money every month. I can either invest this money or prepay my home loan. What is the better option?Asked
Answer to this question is very subjective. What is right for you may not be the same for other person.
Let us consider why. The two alternatives that we have are:
Which one is better will be decided based on respective opportunity costs and other personal sentiment factors.
Opportunity costs if you consider prepaying your home loan:
Opportunity costs if you consider investment in mutual funds:
These factors contribute to your decisions. As I mentioned earlier, the decision will rest upon the fact that what priorities have you set for yourself based on your mental set-up, plans for future, risk appetite, and other financial goal (personal or family).
Look for an example to add to your knowledge before you take the decision.
This is a dilemma that faces anyone who has availed a home loan. Some people would look at the loan as a liability and would want to let go of it as soon as possible, while others would rather invest the money in the hope of generating higher returns. Since we are essentially talking of a trade-off between the two decisions, we have to consider the benefits of each decision.
Investing in a Mutual Fund is an opportunity and basic economics talk of the opportunity cost associated with such a decision. Evaluating this opportunity cost would give you a better understanding of what decision to take. Investing in a mutual fund scheme should give you the ability to cover at least the interest rate on your loan. In other words a 8.00% p.a. home loan interest rate means you should make at least 8.00% p.a. on another investment. Home loans do provide you with certain tax benefits. You can factor this into your calculations to get a better idea. Consider the 8.00% home loan interest rate, if the marginal tax rate is 30%, your effective cost comes to 8% X 0.7 = 5.60%.Investing in a Mutual Fund scheme, that generates returns more than 5.60% for a year would in essence cover your home loan cost.
Investing in balanced mutual funds have historically generated returns that should help you meet the average interest rate on home loans. Balanced Funds like Escorts Balanced Fund - Growth and UTI Balanced Fund - Growth have generated annualized 3 year return of more than 10.00% p.a.
Balanced funds invest part of the total corpus in equity, and part in debt securities. Investing in debt securities help you earn regular income that can help in repayment of EMIs. This way your risk of investing in mutual funds is hedged to a certain extent and you can also benefit from upswing in the equity market. You can extend this understanding to other loans as well.
Hope this answers your question!
Pre-paying home loan or investing in mutual funds is a dilemma that people face. In order to decide what should be done, let’s look at few criteria
· If a person in his early stages of loan i.e when his principal amount in the instalment paid is high as compared to the interest, then the person should first clear up some amount of his loan and then start investing in the mutual funds.
· Rate of compound interest of the home loan is also a factor in taking this decision. The returns from mutual fund should be more than the interest paid on home loan, then only it makes sense to invest in mutual funds.
· Tax benefits should also be taken into account while taking a decision on what to do in this matter.
· Objectives of investment should also be very clear in the mind of an investor. If an investor is looking to invest for a long period i.e more than 3 years then definitely investing in mutual funds is a better option.
· Having the burden of unpaid home loan has an impact on the minds of people while they take the decision. So if a person is very comfortable with the fact that he has unpaid home loan and can still invest, then he should go ahead and invest.
Experts suggest that investing in a mutual fund should be preferred over pre-paying home loan since in realistic situation, returns that an investor gets by investing is generally higher than interest paid in home loans. Moreover if investment has to be made, then investor should prefer to invest in balanced fund.