Have you finally started saving enough that you have some money left over after your minimum loan payments. The logical choice may seem to be paying off your debts as early as possible. But is it the best financial game plan? In certain situations, it may be better to maintain your loan i.e. paying the required monthly instalment and investing the excess cash.
These guidelines will help you in deciding what to do, whether prepay the loan or invest your savings?
- Take care of your needs first: Before you can even consider investing, make sure that you actually have extra money. Have enough money at hand, to pay atleast your monthly home loan EMI on time, everytime. Getting behind on your monthly payments will not only have a detrimental effect on your credit score plus the fees of late payment will be significantly higher that any returns on investment. So, make your minimum monthly EMI payments on time at all costs.
- Setup a Fund for Bad times: Things may be looking up now, but what if you lose your job next month or have a medical emergency. Put away three to six months expenses in cash as an emergency cash fund, depending upon your cash needs, your job security and family situation. You don’t want to take a Credit card debt at 20% interest just to make ends meet because you spent your excess income in prepaying a 10% interest rate home loan. So, save for a Rainy day.
- Think of Loan prepayments as an investment: Look at it this way, if you make a prepayment of Rs. 1000 on a loan with 10% interest, you annual return is Rs. 100. Why? Because now you don’t have to pay that 100 Rs in the future which leaves you with 100 Rs more that you would had otherwise.This will help you in the next process.
- Compare Loan’s Interest vs Expected returns: If Loan prepayment is an investment then, return on investing your savings for prepayment of loan is equal to the annual interest rate of the loan. The higher the interest rates, the higher the incentive to paying off the loan early.
Compare your investment return rates to the interest rate of loan
If your Expected rate of return is greater than the Interest rate on the loan than consider saving.
Let’s take a hypothetical example. Mr Suresh has a home loan of 20 lacs at 9.9% with a tenure of 10 years. His EMI comes out to be Rs. 26,320. He has additional saving of Rs 10,000 every month which which he is considering to prepay the loan.
Saving by Prepayment of Loan
|Excess Income left unused||Excess income used to Prepay|
|Principle Loan Amount||Rs. 20,00,000||Rs. 20,00,000|
|Excess Income||Rs. 10,000||0|
|EMI||Rs. 26,320||Rs. 36,320|
|Loan tenure||10 years||6 years, 2 months|
|Total amount Paid during loan duration||Rs. 31,58,343||Rs. 26,77,473|
In this way he can pay the entire loan in 6 years, 2 months. His total interest savings by prepaying the loan by using excess amount would be around Rs. 4,81,000.
Although it seems like a smart choice, but still there can be a better choice.
If Mr Suresh invests rather invests this 10,000 each month for 6 years in a 10 year bond with expected annual rate of return of 11%
His total returns will then come out be Rs. 8,70,776.
Returns generated by investing in this hypothetical case are Rs. 3,89,776 more than the money saved by prepaying the loan.
Thus, Mr Suresh will miss out on Rs. 3,89,776 because he did not invest his income in those 6 years rather chose prepaying his loan.
- Invest only when you expect assured risk free returns that are higher than the interest rates: Consider the risk in your investment. Most investments usually carry an uncertainty, higher the uncertainty, higher the expected return. In above case, if Mr Suresh is sure to have a risk free rate of return of 11%, then he should definitely invest. If a low risk investment like government bonds is having a higher rate of return than your interest rate than, it is best to pay only the minimum amount towards loan repayment and start investing.
Conclusion: As a thumb rule, if your expected rate of return on investments is greater than the interest on loan than you should invest your savings. But, make sure that Investment should come with the least amount of risk possible. Further keep in mind, some Investment earnings are tax deductible. So, returns of investments need to be significantly higher (at least 1%) than loan interest rate. If your expected rate of return on investments is at least 1% higher than your home loan interest rates, then we advise you to Invest your Savings.