« Goal-based investing: How to save for children's future I have just started earning and do not know a lot of finance. What now? »

Should you prepay your home loan or invest instead?

Posted on 23 Mar 2021
Author: Sayan Sircar

Tags: Loans ; House Purchase

8 mins read
📢Join 3500+ readers on WhatsApp and get new post notifications!

Quickly figure out if you should prepay your home loan vs investing in the stock market?

Saving money

You have a home loan for which you pay EMI monthly. You have extra money every month that you need to utilize: typically invest as per your goals or prepay the loan. Maybe you even got some extra cash as a bonus or maturity of FD or insurance. Read on to find out what you should do next.

This article is the next part of our guide to purchasing your dream home. Read the other parts here:

📚 Topics covered:

Introduction
How a home loan works?
What happens when you prepay a loan
The alternative to investing the extra as per goals
The bottom line

Introduction

Personal finance is more personal than finance. - Tim Maurer

Home loan prepayment is a classic example of this adage being true. There are two parts to the definition of personal finance that leads to this quote.

The first, the Finance part, is pure mathematics and has to be proved or acted upon based on a mathematical calculation. A good example is that paying off a credit card balance (at a 36% interest rate) is better than buying stocks whose returns are uncertain.

The second, the Personal part, is tied to the investor’s behaviour. It, therefore, causes all sorts of issues in implementing something that should have been straightforward mathematics, both good and bad. An example of personal behaviour is the willingness to let investments rise higher and higher in a bull market rather than book profits via rebalancing.

Sometimes, these behavioural biases can become extremely powerful to overcome the rational answers provided by the formulaic part of personal finance. Therefore, we will tackle the current point at hand - prepayment of a home loan - from both aspects - the mathematical and the emotional. For many people, the peace of mind that comes with being debt-free cannot be counted in money terms.

How a home loan works?

Mortgage payment vs home equity

The bank gives a home loan to own the property while you use it until you pay back the loan via EMIs. An Equated Monthly Instalment plan (EMI) is a standard way to pay off a loan by making a fixed payment monthly that includes both interest and principal in the same amount.

EMI = Principal + Interest

In each EMI, the split of the interest and principal changes since the interest is based on the outstanding loan balance at that point and the rest of the EMI is principal. As the chart shows, the interest part drops off with time, and the rest is the principal. The actual numbers in the chart relate to a ₹50 lakhs home loan taken at 8% for 25 years. The EMI is ₹38,591. The down payment amount is ₹12.5 lakhs.

You can test the numbers using this calculator:

As you pay back the loan, your ownership share in the house will increase in the same way. At the point of taking the loan, you own 20% of the house (12.5 out of 62.5, of which 50 is the loan). The bank owns 80%. As the loan is repaid, you own more and more of the house as the principal is paid off. This is the concept of building equity in an asset. Equity is the part of the asset you own after subtracting the part that the bank owns.

Home equity value = Current home value - Outstanding loan balance

Once you build equity in your home, that has additional benefits:

You can take a top-up loan in case you need money for some other purpose like home improvement or any other reason.
The more you will get to keep if you sell the house.

Did you know that we have a private Facebook group which you can join for free and ask your own questions? Please click the button below to join.

What happens when you prepay a loan

You will get a guaranteed return on money when you prepay a home loan

CLICK TO TWEET

When you prepay a loan, the principal immediately reduces by the amount you prepaid. This payment directly shortens the loan tenure if EMI remains the same. You can also ask to switch to a smaller EMI, keeping the same loan tenure. Ideally, you shouldn’t reduce EMI unless you cannot manage monthly expenses. If your loan tenure comes down, the interest you pay reduces. This interest savings due to principal reduction leads to a return on the amount you just prepaid equal to the (after-tax) rate of the loan. So for a home loan at 8% (after-tax savings on principal + interest, say 6-7%), this is a return that is guaranteed. Additionally, you end up owning more and more equity in your home more quickly.

Also read
Don't stop investing when the markets are down

The alternative to investing the extra as per goals

Generally, goal-based investments assume an overall return (usually from equity) higher than the loan’s effective rate. This is true, at least historically and but is not guaranteed. If we assume this to be accurate, paying only the EMI is better since the extra money can be invested for long-term goals in equity markets to get more returns.

There is a small caveat here regarding opportunity cost. Suppose you do not have a loan. In that case, your opportunity cost of investing in equity is a debt fund that returns lower than the cost of the loan itself. So you take some risk or uncertainty to hopefully get returns higher than a debt fund by investing in equity. On the other hand, your opportunity cost is lower with a loan since the loan rate is more. So essentially, you take the same risk while the opportunity cost is lower.

The bottom line

Pre-pay: If being free from a loan is what you want more than anything, prepay some or all of the extra money. This will reduce the funds available for future goals, but it will give you the peace of mind you want to get. You can also prepay if you have funds and your home loan interest rate is going up.

Invest: Consider the loan to be like a PPF-type debt instrument with a known return (after-tax interest rate of the loan) and lock-in equal to the remaining tenure of the loan. Once prepaid, the money will not come back. If you have an SBI Maxgain type of loan, the lock-in will not be there. There are already investments made in long-term debt products like PPF/EPF/VPF/Sukanya Samriddhi etc. Consider the loan to be another such long-term debt product and invest as per your asset allocation.

In either case, you should perform a recalculation of your entire portfolio using a comprehensive planner (like this) to see where this allocation should be made to debt or equity. If the allocation comes to debt, prepay the loan with that amount. Keep in mind that unless you have a home loan like SBI Maxgain, you cannot bring out the money you have invested into the loan. It is generally a one-way transfer.

You should not prepay the home loan if your asset allocation does not allow it. For example, this may happen if the portfolio is already debt-heavy or the goals are such that you cannot rebalance the portfolio further into debt.

Read more on asset allocation and rebalancing here:

What's next? You can join the Arthgyaan WhatsApp community

You can stay updated on our latest content and learn about our webinars. Our community is fully private so that no one, other than the admin, can see your name or number. Also, we will not spam you.

For resident Indians 🇮🇳:

For NRIs 🇺🇸🇬🇧🇪🇺🇦🇺🇦🇪🇸🇬:

Share on WhatsApp:

To understand how this article can help you:

If you have a comment or question about this article

The following button will open a form with the link of this page populated for context:

If you liked this article, please leave us a rating

The following button will take you to Trustpilot:

Discover an article from the archives

Previous and next articles:

<p>Save for children’s schooling, college education and marriage via goal-based investing.</p>

Children Set Goals

Goal-based investing: How to save for children's future

Save for children’s schooling, college education and marriage via goal-based investing.

Published: 17 March 2021

10 MIN READ

<p>Part 1: As someone who is new to investing and started earning, what should I do with my money?</p>

Basics

I have just started earning and do not know a lot of finance. What now?

Part 1: As someone who is new to investing and started earning, what should I do with my money?

Published: 28 March 2021

3 MIN READ

Latest articles:

<p>This article simplifies compliance for US, Canada, UK, and Australia-based NRIs, covering FBAR, FATCA, PFIC, and T1135 requirements.</p>

NRI Tax

What NRIs Must Do With Indian Investments Before the Year-End? PFIC, FATCA, DTAA and ITR rules Simplified

This article simplifies compliance for US, Canada, UK, and Australia-based NRIs, covering FBAR, FATCA, PFIC, and T1135 requirements.

Published: 18 December 2024

6 MIN READ

<p>This article explains the basics of SEBI’s new Specialised Investment Funds which offer advanced strategies that mutual funds cannot and is suitable for investors below the PMS ₹50 lakhs threshold.</p>

FAQ News

Frequently asked questions (FAQs) on SEBI's new Specialised Investment Funds (SIF) which sit in between Mutual Funds and PMS

This article explains the basics of SEBI’s new Specialised Investment Funds which offer advanced strategies that mutual funds cannot and is suitable for investors below the PMS ₹50 lakhs threshold.

Published: 17 December 2024

1 MIN READ

Topics you will like:

Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself.

Don't forget to share this article on WhatsApp or Twitter or post this to Facebook.

Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.

Arthgyaan

Supporting everyone's personal finance journey