Should you invest or prepay your loan?

By BankBazaar.com | December 17, 2010

Equity mutual funds make a great investment. However, given the volatile nature of the market and the loss experienced by investors in the past months, one should keep expectations realistic and be willing to wait it out for at least 10-15 years to see a good return from equities.

To prepay or invest – that is a question most of us ask when we have spare cash in hand. Here’s how to take the decision.

Amar bought a re-sale apartment three years back, for which he took a loan of Rs 7 lakh at 8.5 per cent. He pays a monthly installment of Rs 6,500. Now, he wants to invest his monthly saving rather than use it to prepay the loan; but is unsure. His monthly income is Rs 50,000.

Amar could actually do both – make part prepayment and invest too. Here’s how.

Prepay in installments:
Amar can use part of his savings to prepay the loan thus reducing the tenure. Since his loan amount is less burdensome compared to the income, he can part prepay at intervals. The thumbrule is that loan EMIs should not exceed 30 per cent of monthly income. In Amar’s case, he is well within the limit. Here’s what he can do:

Step 1: Set aside 20 per cent of his income for home loan repayment
Step 2: Accumulate this amount every three months and make a quarterly prepayment
Step 3: Check with the bank if any pre payment charges are applicable. If yes, he will have to plan the pre payment accordingly to avoid charges. For instance, some banks allow up to 25 per cent of prepayment without any charges.

The only thing he should keep in mind – the prepayment charge, should be considerably less compared to the interest saved.

Invest smartly:
As far as investing is concerned, he has two options: equity and debt. Based on his risk profile and time horizon, he can make a choice. For investments longer than 5 years he can choose equity. For anything of a lower time frame, it is better to opt for debt.

Equity mutual funds make a great investment. But given the volatile nature of the market and the loss experienced by investors in the past months, Amar should keep his expectations realistic. He must be patient and willing to wait it out for at least 10 to 15 years to see a good return from equities.

On the debt side, bank deposits have gained more popularity lately, because of the high interest rates they have been offering. So, if Amar is looking for a safe avenue along with tax benefits, he could lock his money for a five-year term.

 

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7 thoughts on “Should you invest or prepay your loan?

  1. AvatarGurmeet Singh

    Sir,
    At present PPF is the best option to invest surplus saving after meeting your loan EMis. However, loans cost more as compound interest is chared. But given the tax benefit of interest paid on house loans, it is the best option to repay EMI only and save in the PPF offering 8.5% PA 'tax Free" returns.

    You Know?

    Reply
  2. AvatarVM

    Hello sir
    I have a home loan principal balance of 11.5 L. I am paying an EMI of 21500 per month for balance tenure of 80 months. I have a monthly salary of 80 K. Some of my previous savings are maturing in the next 4 months and I'll be having 6 L in hand.
    Would you suggest me to re-invest my savings (if yes – where?) or pre-pay my homeloan and reduce the tenure. There is no pre-payment charge on my loan upto 75% pre-payment.
    Regards

    Reply
  3. Avatarbharathi

    Hi VM,

    If you consider there is no risk for the standard appreciation value of your home, you can very well make a prepayment apart from maintaing a minimal savings for your emergencies. This will be wise decision considering socail setup and dynamic economy. You can think of any investment from your earnings, which is appropriate on course of 2-3 years time.

    Reply
  4. AvatarAV

    Hi VM, As a general reader, first priority to make home free from any loan committments …Once this done, you can view or review reinvestment …max effort must be done to secure your property which is a growing asset …

    Reply
  5. AvatarMurty

    This is a false claim on various fronts:
    1. Three years back there was no 8.5% interest.
    2. A Seven lakh loan with Installment of Rs.6500? Means it is a 20 year loan?
    3. A person with Rs.50000 salary is bound to pay heavy taxes. Hence it is not suggested to prepay. Instead, he should get another house, however, it is a separate issue.
    4.The 20 year loan of 7.5 Lakh rupees will have a an interest bearing around Rs.60000 Per annum.This is far below his capacity to pay with Rs.50000 Salary.However, you can not claim on this amount, as this 50000 is before taxes or after taxes, we are not sure.
    5. Last but not the least, the investment advise is just a copy of many other advises online and it is like MAANO.(Much ado about Nothing)

    Reply

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