Prepay Home Loan or Invest?

As someone who knows very little about home loans, the popularity of the titular question never fails to surprise me.

When this question was asked again in the facebook group, Asan Ideas for Wealth (AIFW), I learnt something new. Here is an account of my understanding. I thank the members of AIFW for their insight.

Sometime back, on Subras request, I made a prepay home loan or invest for retirement calculator and realised that unless one wishes to retire early, there is no flaming hurry to pre-close a loan.

First let look at this issue from both angles

Invest and let the loan run its course 

  1. After all, salaries will increase and inflation, which is comparable to home loan rate, will slowly, but surely diminish the value of the EMI.
  2. There are more obvious incentives to continue the loan. Even if there is no tax benefit from the principal component, since 80C is maxed out for most, the interest component is eligible for a decent tax deduction. The tax save can make a difference if invested
  3. Since the interest component is high for the first half of the loan duration, it makes sense to let the loan run at least for half the stipulated period and then pre-pay it.
  4. Investing now will maximize the effect of compounding. What if you cannot build a large enough corpus for retirement or fund other goals?

 Notice that all arguments are mathematical in nature.

Prepay, close out the loan asap and then invest

  1. Why be in debt? Feels like a sword hanging over the neck. I can’t think clearly. My parents are urging me to get out asap.
  2. Why not actually own the home asap and then invest?
  3. What if interest rates increase? I have a high enough emi as it is!

 Is the 3rd argument the only mathematical one?

Let us now look at an imaginary but typical scenario.

  • Akash is a 30 year old, married and with a 2 year old daughter.
  • Gross annual income ~ 15.4 Lakhs. Annual growth 10%
  • Monthly expenses ~ Rs. 40,000; Inflation 8%
  • Home loan (self-occupied): 60 Lakhs; Rate: 10%; Tenure 20 year; EMI: Rs. 57,901;
  • Retirement 30 years away
  • Daughter education 16 years away
  • Daughters marriage 23 years away
  • Section 80C limit: 1 Lakh  (home loan principle is assumed to be not part of deduction)
  • Section 24(b) limit (home loan interest deduction): Rs. 1, 50,000

Akash has now obtained a lump sum of Rs. 3 lakh. Should he invest it or use it for pre-paying?

For both scenarios, we assume that

  • Akash invests his salary after accounting for expenses, EMI, 80C deductions, tax. The tax saved from section 24(b) is also invested.
  • Akash continues such investing after the end of the loan up to retirement
  • The investment is assumed to grow each year at the average rate of 10% and when the need arises –daughters education 16 years later; wedding 23 years later – redemptions are made from the same account.
  • Only long term goals are considered.

Which is better? Investing or prepaying?

Have a look and judge for yourselves. I am automating this Excel sheet so that inputs can be varied at will.

prepay

 

If the lump sum was pre-paid, Aksash will fall short of the corpus required for financial independence. Please don’t argue, not by much! Remember the numbers used here are imaginary. Until you punch in your own numbers, you will not know for sure.

Had he invested the lump sum, he would have got a corpus much higher than that required.

Had Akash, postponed the purchased of the house, would have done much better? Perhaps - shall include this option in the calculator to find out.

So which is better?

If we look only at the graph, Investing the lump sum is better.

Not because he will fall short of the retirement corpus needed, but because it is not practical to assume that future cash inflows will be used for investing! We cannot be so sure about the future.

When you have money, invest – right now! Do not assume you will invest from your higher salary 5 years later. That may happen may not happen. Investing now, will get time on your side.

 Prepaying is not terrible!

Frequent prepaying makes sense only when the EMI is very large – more than 50% of net take-home pay.  In such a case the person will feel stifled and it makes sense to at least shorten the suffering. So pre-paying in chunks, every few months does have an appeal.

When our salary is accounted for completely by EMI, expenses and taxes, we cannot

So  even this suggestion is mathematical and not just governed by emotions. So even the sword above our neck feeling is grounded in math for those with high EMIs!

The point is, analyse your financial situation holistically before making a decision. There is no need to choose one or the other (investment or prepayment).

You can always follow the middle path – invest some, prepay some.

In any case, remember to consider all your goals in the analysis. Give me a few days to automate the analysis tool.

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47 thoughts on “Prepay Home Loan or Invest?

  1. Young graduate

    I'm having the same dilemma now. My education loan EMI comes to 21700 which is 25% of my post tax salary. I just got a lump sum of 2.5 lakhs. Choosing to put it into a liquid fund and waiting for the right time to transfer into equity fund.

    Reply
    1. pattu

      Hi, since you have age on your side, prepay the loan in small chunks every few months and get rid of it. I understand there are tax perks, but I think you will have to weigh that against possible job loss and lower pay. Just keep continuing investing no matter what.

      Reply
      1. Young graduate

        My portfolio is pure equity (since EPF + 10% VPF is enough for fixed income IMO) equally in three funds. Quantum LTE, ICICI Discovery and Mirae Emerging Business. Is it better to do STP or do a bulk investment when the PE of the fund goes down? I'm planning to close my loan at least two years early by living frugally. Mumbai rents are way too high!

        Reply
        1. pattu

          A fund PE is just the average PE of underlying stocks, which will change when the portfolio is churned. So it does not carry much significance. My advice to you would be to simply invest over a few months manually on days the index drops by 1% over a couple of days. Your aim should be to get as much capital in as possible in the markets for it to grow. When your holdings are large, you can think about tactical asset allocation by looking at index PE

          Reply
  2. Young graduate

    I'm having the same dilemma now. My education loan EMI comes to 21700 which is 25% of my post tax salary. I just got a lump sum of 2.5 lakhs. Choosing to put it into a liquid fund and waiting for the right time to transfer into equity fund.

    Reply
    1. pattu

      Hi, since you have age on your side, prepay the loan in small chunks every few months and get rid of it. I understand there are tax perks, but I think you will have to weigh that against possible job loss and lower pay. Just keep continuing investing no matter what.

      Reply
      1. Young graduate

        My portfolio is pure equity (since EPF + 10% VPF is enough for fixed income IMO) equally in three funds. Quantum LTE, ICICI Discovery and Mirae Emerging Business. Is it better to do STP or do a bulk investment when the PE of the fund goes down? I'm planning to close my loan at least two years early by living frugally. Mumbai rents are way too high!

        Reply
        1. pattu

          A fund PE is just the average PE of underlying stocks, which will change when the portfolio is churned. So it does not carry much significance. My advice to you would be to simply invest over a few months manually on days the index drops by 1% over a couple of days. Your aim should be to get as much capital in as possible in the markets for it to grow. When your holdings are large, you can think about tactical asset allocation by looking at index PE

          Reply
  3. Ramesh

    I have a small query here. The home loan rate is 10%. The investment growth rate is also 10%. Then why should there be any discrepancy in the two scenarios. Mathematically, there should be no difference.

    Is the perceived difference only because of the tax benefit on the Interest component.

    Do look at the data. What if the investment rate of return is say 9% (less than home loan rate)?

    Reply
    1. pattu

      The difference between the two scenarios is because of the 3L lump sum - invested in one case and pre-paid in the other. If that was not there then both graphs will merge.

      Reply
      1. Ramesh

        What about the reduction in the total EMI duration, when that 3L has been prepaid?

        My point is there should not be much of a "mathematical difference" between the two, since the marginal difference between the home loan rate and the investment rate of return is Zero, in this case (10% each).

        Can you send me the raw data excel?

        Reply
  4. Ramesh

    I have a small query here. The home loan rate is 10%. The investment growth rate is also 10%. Then why should there be any discrepancy in the two scenarios. Mathematically, there should be no difference.

    Is the perceived difference only because of the tax benefit on the Interest component.

    Do look at the data. What if the investment rate of return is say 9% (less than home loan rate)?

    Reply
    1. pattu

      The difference between the two scenarios is because of the 3L lump sum - invested in one case and pre-paid in the other. If that was not there then both graphs will merge.

      Reply
      1. Ramesh

        What about the reduction in the total EMI duration, when that 3L has been prepaid?

        My point is there should not be much of a "mathematical difference" between the two, since the marginal difference between the home loan rate and the investment rate of return is Zero, in this case (10% each).

        Can you send me the raw data excel?

        Reply
  5. Prashant V.Joglekar

    Dear Sir, I am a regular follower of your articles. And a user of excellent calculators prepared by you. This is a kind of social welfare cause done by you for the distributors and the investors.

    My request to you is to prepare a Brokerage calculator for the Mutual Fund distributors. because as you are aware of ,calculation of trail & upfront commission is not so easy.Particularly SIP bus. Also a distributor is unable to set a target for the business (say I want to earn 5,00,000/- brokerage in next 3 years , what amount of SIP bus. should I aim for?).

    My best wishes to you & your team. You people are doing great job. keep it up..

    Reply
  6. Prashant V.Joglekar

    Dear Sir, I am a regular follower of your articles. And a user of excellent calculators prepared by you. This is a kind of social welfare cause done by you for the distributors and the investors.

    My request to you is to prepare a Brokerage calculator for the Mutual Fund distributors. because as you are aware of ,calculation of trail & upfront commission is not so easy.Particularly SIP bus. Also a distributor is unable to set a target for the business (say I want to earn 5,00,000/- brokerage in next 3 years , what amount of SIP bus. should I aim for?).

    My best wishes to you & your team. You people are doing great job. keep it up..

    Reply
  7. Krishna

    Pattu,

    I am also in same dilemma. I have surplus of 40k . Whether I should pre pay my car loan or to contribute to emergency fund. At the moment my car EMI is 4300

    Reply
    1. pattu

      If your emergency fund is less than 6 months expenses, add the 40K to it. You could then prepay this loan with another lump sum.

      Reply
        1. Krishna

          Pattu,

          Sorry to ask you a question entirely off the topic, should we redeem the MFs which are 1 year old and re invest them under Direct Scheme ?

          Krishna

          Reply
  8. Krishna

    Pattu,

    I am also in same dilemma. I have surplus of 40k . Whether I should pre pay my car loan or to contribute to emergency fund. At the moment my car EMI is 4300

    Reply
    1. pattu

      If your emergency fund is less than 6 months expenses, add the 40K to it. You could then prepay this loan with another lump sum.

      Reply
        1. Krishna

          Pattu,

          Sorry to ask you a question entirely off the topic, should we redeem the MFs which are 1 year old and re invest them under Direct Scheme ?

          Krishna

          Reply
  9. Yogesh Sundaram

    Investment returns are random. One should always prepay his/her liabilities with surplus cash flows. Always better to extinguish a liability rather than bank on optimism; Being conservative always pays and remember that you're a Black Swan,. Math is absolutely irrelevant here. In fact ask any financial institution, the average duration of 20 year home loans book is about 8 or 9 years which tells u a story. In the US, the average duration on mortgage loans is about 10 years and that is why interest rate risk on Mortgage backed securities are hedged using 10 year treasuries.

    Reply
    1. pattu

      I agree with you. My only point is, we should define 'surplus cash flow' after taking investments into account. At least one must be aware of then impact of preclosure on investments esp for retirement.

      Reply
  10. Yogesh Sundaram

    Investment returns are random. One should always prepay his/her liabilities with surplus cash flows. Always better to extinguish a liability rather than bank on optimism; Being conservative always pays and remember that you're a Black Swan,. Math is absolutely irrelevant here. In fact ask any financial institution, the average duration of 20 year home loans book is about 8 or 9 years which tells u a story. In the US, the average duration on mortgage loans is about 10 years and that is why interest rate risk on Mortgage backed securities are hedged using 10 year treasuries.

    Reply
    1. pattu

      I agree with you. My only point is, we should define 'surplus cash flow' after taking investments into account. At least one must be aware of then impact of preclosure on investments esp for retirement.

      Reply
  11. Vinayak

    Sir,

    Your article is really helpful.

    Let me know if one should prepay his first home loan & opt for second home loan which will help with higher tax savings & rental income??

    Reply
    1. pattu

      Thanks Vinayak. I dont follow your question. How is rental income related to second home loan. Kindly first check if you investing enough for retirement and other long term goals and then decide about a second home loan.

      Reply
  12. Vinayak

    Sir,

    Your article is really helpful.

    Let me know if one should prepay his first home loan & opt for second home loan which will help with higher tax savings & rental income??

    Reply
    1. pattu

      Thanks Vinayak. I dont follow your question. How is rental income related to second home loan. Kindly first check if you investing enough for retirement and other long term goals and then decide about a second home loan.

      Reply
  13. Jaydip Mehta

    In my view, biggest assumption here is "The investment is assumed to grow each year at the average rate of 10%" .. this rate is same as your home loan rate and SO prepayment can never make sense because of compounding of interest for investment option .. i have just downloaded calculator, let me punch-in numbers that suits me (from investment return perspective), and will post it here if it makes sense to prepay/invest home loan amount for ME ...

    Reply
  14. Jaydip Mehta

    In my view, biggest assumption here is "The investment is assumed to grow each year at the average rate of 10%" .. this rate is same as your home loan rate and SO prepayment can never make sense because of compounding of interest for investment option .. i have just downloaded calculator, let me punch-in numbers that suits me (from investment return perspective), and will post it here if it makes sense to prepay/invest home loan amount for ME ...

    Reply
  15. Pattabiraman Murari

    Jaydip, the investment is assumed to grow at an average rate of 10%, yes but that 10% need not, and will not be the return each year in a volatile instrument like equity. Which is perfectly fine. If the average return could be much more than 10%, there is no sense in pre-paying.

    Reply
  16. Pattabiraman Murari

    Jaydip, the investment is assumed to grow at an average rate of 10%, yes but that 10% need not, and will not be the return each year in a volatile instrument like equity. Which is perfectly fine. If the average return could be much more than 10%, there is no sense in pre-paying.

    Reply
  17. Monica Cam

    I am Mrs Monica Cam I was in a critical search of a genuine loan
    lending company were i can obtain a loan of $90,000.00 some people
    who carry there self as a loan lender’s,Came to me sheep clothing i
    never knew they where frauds until i was given the terms of their
    loan and i agreed eventually i was scammed they scammed me of my hard
    earn money up-to four lender’s that scammed me the sum of $12,000.00
    and i though that all is over that there can never be any other
    genuine lender on the net until my Husband’s Friend lee San told me
    that there is a genuine lender that he obtained a loan of $550,000.00
    At 2% interest rate, the this loan company makes him own a private
    business and a house of his own he Referred me to Loan Offer company
    ,E-mail:jamesowen0099@gmail.com or jamesowen09@yahoo.com Where he
    obtained loan of ($550,000.00 ) i told them how referred me to them
    i applied for a loan of $90,000.00 after my application and i sent to
    them the useful information for them to process my loan after 48hours
    i received a notification From the company that my loan has been
    approved and processed in the next 48hours my loan of $90,000.00 was
    transferred into my account. And i promise them for coming to my
    rescue i am going to spreed the good news to the entire world ABOUT
    JAMES OWEN LOAN COMPANY IS THE BEST IN THE WORLD.please all loan
    seekers should be very careful on the net there are a lot off scams
    out there, And tell them i Mrs Monica Cam referred you to them and
    your wish will be fulfilled ?Thanks be to God for my life you all we
    also have your testimony to spreed to the world

    Reply
  18. Monica Cam

    I am Mrs Monica Cam I was in a critical search of a genuine loan
    lending company were i can obtain a loan of $90,000.00 some people
    who carry there self as a loan lender’s,Came to me sheep clothing i
    never knew they where frauds until i was given the terms of their
    loan and i agreed eventually i was scammed they scammed me of my hard
    earn money up-to four lender’s that scammed me the sum of $12,000.00
    and i though that all is over that there can never be any other
    genuine lender on the net until my Husband’s Friend lee San told me
    that there is a genuine lender that he obtained a loan of $550,000.00
    At 2% interest rate, the this loan company makes him own a private
    business and a house of his own he Referred me to Loan Offer company
    ,E-mail:jamesowen0099@gmail.com or jamesowen09@yahoo.com Where he
    obtained loan of ($550,000.00 ) i told them how referred me to them
    i applied for a loan of $90,000.00 after my application and i sent to
    them the useful information for them to process my loan after 48hours
    i received a notification From the company that my loan has been
    approved and processed in the next 48hours my loan of $90,000.00 was
    transferred into my account. And i promise them for coming to my
    rescue i am going to spreed the good news to the entire world ABOUT
    JAMES OWEN LOAN COMPANY IS THE BEST IN THE WORLD.please all loan
    seekers should be very careful on the net there are a lot off scams
    out there, And tell them i Mrs Monica Cam referred you to them and
    your wish will be fulfilled ?Thanks be to God for my life you all we
    also have your testimony to spreed to the world

    Reply
  19. Nikhil

    Could you please elaborate the third point under 'Invest and let the loan run its course'?

    If one is going to prepay the loan, doesn't it make sense to do it in the first half, when the impact would be the highest?

    There is less of an incentive to prepay when you have already paid most of the interest and now the principle component has a much higher proportion in the EMI?

    Reply

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