How to decide when to prepay your Home Loan

Should you invest in tax-free bonds or prepay home loan ? 

*The market is flooded with tax free bonds. Besides the three existing
offerings (see table), the National Housing Bank is also expected to hit
the market soon.*


*These are compelling investment options because the tax-free interest
rates offered are very high and almost comparable with the pre-tax rates on
bank fixed deposits.*

*The decision may not be that easy for those with a home loan to pay. The
common refrain is that if there is any surplus money, shouldn't it be used
to prepay the loan? Most borrowers may opt to prepay their loans than invest
in tax-free bonds. If you are faced with the same dilemma, consider these
factors before you decide.*

*Look at prepayment as an investment*

*Much of the confusion gets cleared if you see debt prepayment as just
another investment. If you prepay Rs 1 lakh of a personal loan which was
charging you an interest rate of 15%, you save Rs 15,000 in interest per
annum.*

*And since money saved is money earned, your Rs 1 lakh will effectively
earn you Rs 15,000 in a year. That's a good return and should be the first
option for anybody with surplus cash. Evaluate your debts on the basis of
the interest you are paying and start with repaying the costliest ones.*

*The credit card balance and personal loans should be the first in your
cross-hairs. It doesn't make sense to keep money in a fixed deposit that
fetches only 9% when you have a credit card outstanding with interest cost
of around 42% and personal loans with interest cost of around 15%.*

*But you may also encounter situations where the loans are cheaper than
what your investments can earn. That's when you should stop prepaying the
loan and start investing. "Follow the simple rule that the return from the
investments should be more than the interest on the loans," says Jaya
Nagarmat from Investor Shoppe.*

*A small caveat here: You must also consider the risks involved in the
investments when you make the comparison. You should only consider
relatively safe investments such as bank fixed deposits and bonds.*
*Take tax into consideration*

*The maximum returns offered by the taxfree bonds currently on offer is
8.92%, so the prepayment of loans continues to be a viable option if one
goes with the above mentioned simple rule. However, the tax benefits on
certain loans can change the equation in favour of investing. The effective
cost of some loans comes down if the tax benefits on the interest is taken
into account.*

*"Interest paid on education loan is deductable for 8 years from the
starting date of repayment," says Sandeep Shanbhag, director, Wonderland
Consultants.*

*For someone earning over Rs 10 lakh a year, the cost of the education loan
comes down from 13% to 8.98%. Similarly, the effective cost of a housing
loan at 10.25% also comes down to 7.08% for the borrowers in the 30.9% tax
bracket. "The investor should not prepay the housing loan if he is in the
highest tax bracket. Else, he can pay off the loan instead of investing,"
says Nagarmat.*

*Here's another caveat: if the house is self-occupied, you can claim a
maximum deduction of Rs 1.5 lakh in a year. If your loan amount is very
large and the annual interest far exceeds the Rs 1.5 lakh limit, it may
still make sense to prepay the home loan than invest in the bonds.*

*There is no limit on the deduction of the interest if the house has been
rented out. Another point that needs consideration is the tax treatment of


the returns from the investment. The post-tax return of a fixed de- posit
that offers 9% is only 6.22% for an investor in the 30.9% tax bracket. This
is below the 7.08% effective cost of the housing loan.*

*But the 8.92% coupon rate offered on tax-free bonds is significantly
higher than the effective cost of the housing loan for investors in the
20.6% and 30.9% tax brackets. These investors should use surplus funds in
this order: first invest in tax-free bonds, then prepay home loan and
lastly invest in FDs.*

*Interest rates are expected to fall once the RBI is done with its measures
to stabilise therupee and control inflation. If rates fall, the tax-free
bonds should fetch good returns in the medium to long term. However, don't
think that this strategy is completely devoid of risks. "One has to look at
the possible downside also and not just the possible upside," cautions
Shanbhag. This is because most housing loans are not fixed but at floating
rates of interest.*

*In the unlikely event of rates going up, the EMI will also rise. On the
other hand, the value of the long-term taxfree bonds in the secondary bond
market will come down.*

*Future requirements*

*The future cash flow requirement is another thing to consider when
prepaying your home loan. It is always better to keep some extra money in
hand for contingencies. If you prepay your housing loan to your maximum
ability and need money in future for some unexpected event, you will be
forced to go for personal loans. Even if you have a good credit score, a
personal loan is far costlier than a home loan.*

*To conclude, some debts (such as a home loan) are not bad and should not
be prepaid aggressively. Irrespective of whether or not you prepay your
loan, the ultimate objective is to have a large pool of investments and no
debt by the time you retire. All these debt versus investment discussions
are only short-term decisions.*

*Source : Economic Times *