When is the right time to prepay your home loan?

A home loan is a burden you’d like to take off your chest as soon as possible. Especially when you have enough money at hand or the equity market is performing reasonably well and interest rates are also lower than usual. However, a financial dilemma arises just then: Should you rather ‘invest’ the excess money or use it to pay off an outstanding loan? When is the right time to prepay and does it apply unanimously for everyone?

“There is nothing as a right time or a wrong time to repay the home loan. If there is liquidity, the loan should be repaid. Various factors to be considered are future cash flow requirements, the outstanding amount compared to the other assets owned, and most importantly whether the loan is on the house that we stay in,” Forum Shah, CFP, said.

When is the right time to prepay debts?

Usually, people believe that if the interest on loan is less than the returns generated from investments, it is okay not to repay and continue with the investment. This is, however, not prudent. The returns that are generated on investments are notional till encashed whereas the interest is a certain payment. Thus it is always better to be debt free.

Yes, borrowers should try to prepay their home loans whenever they have surplus funds. But according to Ratan Chaudhary, head of home loans at Paisabazaar.com, one should never use emergency funds or sacrifice existing investments earmarked for crucial financial goals to prepay loans.

“Doing so can force them to avail costlier loans at higher interest rates to deal with financial exigencies or meet unavoidable financial goals. Home loan borrowers should use online SIP calculators to calculate monthly contributions required to meet their unavoidable financial goals. Any surpluses left after making those investment contributions and other unavoidable expenses can be used for loan prepayment,” Chaudhary said.

Borrowers are always advised to prepay in the first 5 years of taking the loan as it reduces the total interest outgo significantly.

Home loan overdraft

Borrowers can also opt for a variant of home loan called home saver or home loan overdraft option for deriving dual benefits of prepaying loan and preserving their liquidity. Under this option, an overdraft account is opened in the form of a current or savings account and linked with the home loan account.

As per Chaudhary, the borrower can freely withdraw from the balance of the overdraft account whenever he faces fund shortages, “Existing home loan borrowers who wish to avail home loan overdraft option can either ask their existing lender about the availability of this option, or transfer their home loans to other lenders offering home saver or home loan overdraft option.”

Role of post-tax returns

There is a popular rule – if you can generate better post-tax returns than the current interest rate on your home loan, don’t prepay. Does it always hold true?

While home loans have one of the lowest interest rates among all credit options, their interest rates are still higher than pre-tax yield earned from most fixed income instruments.

“For those in the higher tax slabs, the post-tax yield from most fixed income instruments would be much lower than the interest rate charged on home loans. Hence, home loan borrowers should always try to use their surpluses to make home loan prepayments rather than parking them in low-yield fixed income instruments,” Chaudhary said.

Meanwhile, when it comes to equities, the average rate of returns from equities as an asset class usually exceeds the interest rates on home loans by a wide margin over the long term. Hence, home loan borrowers should never sacrifice their existing equity investments or fresh monthly contributions to equities for their long term financial goals to make home loan prepayments.

Use investment profits to prepay?

Is it a better strategy to use profits from your investments to prepay your home loan rather than a bonus or extra money you have saved out of your income? Keep in mind that redemption of investments made in equities, equity funds, debt funds and gold funds can attract capital gains tax on the profits realised and exit loads if redeemed before pre-specified timelines.

“Redeeming fixed deposits before their maturity can attract prepayment penalty. Hence, home loan borrowers should factor in the taxes and charges incurred while redeeming their investments for making prepayments. They should time their redemptions in such a way that it incurs lowest possible taxes and charges on redemptions,” Chaudhary pointed.

Here’s what finally matters

Buying a home is one of the major goals in the life of an individual. Sometimes other goals have to be sacrificed/postponed for this. Repaying a home loan may not be an easy task for everyone depending on the financial responsibilities of the individual. The sooner you can become debt-free, the better it is.

“Thorough analysis of other financial responsibilities and cash-flows should be done when one considers repaying the loan. If the income stream is stable, then regular bullet repayments help to reduce the tenure of the loan drastically by keeping the EMI the same. Ideally, it is always better to repay the loan as and when possible,” Forum added.