Getting a bonus is definitely a joyful experience for one and all. It indeed feels great to be rewarded for the hard work you have put all year round. But what do you do with the lump sum you have received? It can indeed be a dilemma if you have a home loan and cannot decide whether it is a better idea to prepay it or direct your funds towards the right instruments so as to enhance your wealth and augment your long term portfolio.
There is no straight answer to this as it is rather subjective in nature. For some home loan rates may feel like a long term burden that he wishes to eliminate at the earliest because he fears some untoward incident might hamper his cash flow in the future. To others, an EMI on his current home loan interest rate may not feel like a burden as its already being managed with his regular cash flow, and he may be bothered about the fact that he does not have enough savings. As is evident, in both cases, it is the psyche that is important here, although the rule of thumb about personal finances always says that you should clear your debt before you invest.
Prepaying your home loan? Do the math first
The other thing to consider is the taxation aspect. If you are a homeowner, you already know that the principal component of your loan is treated as an investment which makes you eligible for an annual deduction of Rs 2 lakh per annum on your home loan’s interest component. This is in case your house is self occupied. You need to do the math to find out whether your annual interest outgo is higher than Rs 2 lakhs per annum. If the answer is yes, you might as well prepay your loan and save on future payment of interest thus saving money in the process.
However if you and your spouse have jointly applied for the loan and are availing of individual tax benefits of up to Rs 2 lakh each, consider a prepayment only if your outstanding amount exceeds Rs 40 lakhs. It will do you well to bear in mind that by prepaying you may also have to forego of future tax benefits if your annual interest outgo in the subsequent years falls below Rs 2 lakhs.
Consider post tax returns in case of investments
If you think that you are better off making an investment rather than prepaying your loan, the key thing to consider is that your post tax returns from your investment should be higher than the effective cost of your home loan. For instance, if your outstanding amount is less than Rs 20 lakhs and you fall in the 30% tax bracket, your effective cost is 6.65%. You should therefore choose an investment option that potentially gives you higher post tax returns. If making an investment meets this rationale, consider an investment option with your risk profile in mind.
For instance if you are looking at long term returns investing in equities through an equity fund would make sense as it would fetch much higher returns that what you are paying on your loan. A look at SIP returns on equity funds for the past ten years would show that investors will have earned much more than the above mentioned 6.65 % on their investments.
However if equity funds or equities as an asset class is not your cup of tea, you are better off investing in debt related instruments, you may consider a higher contribution to PPF or tax free bonds that fetch high returns as compared to 6-7%. On the other hand, if you think you are covered as far as your long term savings and would rather invest in instruments that would build or augment an emergency fund, consider putting your money in a liquid fund or a short term debt fund for a shorter period of time like 6 months to a year.
What it essentially boils down is your psyche. What we are trying to establish here is that whether it is repayment of your home loan or an investment, you should do so after careful thought and consideration. In any case take your long term financial plan and risk profile into account and see that your decision does not derail your short term or long term financial goals.
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