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Should you prepay your home loan or invest surplus cash?

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When the equity markets are performing well, and interest rates are low, many borrowers wonder whether they should invest surplus money or prepay their home loans.

To decide on this, you will need to evaluate your current situation and determine whether it makes sense for you to prepay or continue with the loan.

As there’s no straightforward answer to the question and expert views differ, it will be your discretionary call.

If you strictly look at numbers, there’s a thumb rule that suggests if you can generate better post-tax returns than the current interest rate on your home loan, don’t prepay. Instead, use that money to invest.

For example, home loans from banks at present could be at 7-7.5% rate. Most planners take 9-10% post-tax returns for equities over the long term. Going by the thumb rule, starting a systematic investment plan for the long term works out to be a better option as the investment returns are about two percentage points higher than the home loan interest rate.

“No one can predict equity market returns. There is a possibility that current valuations in equities are stretched, and over the next few years, the returns may remain subdued. In such a case, the borrower may think that it was a better option to prepay than invest in equities,” said Arnav Pandya, founder of Moneyeduschool, an Ahmedabad-based financial literacy initiative. Therefore, don’t go by the thumb rule alone.

Before you decide on prepaying your home loan, ensure that your basics are covered. You should have an emergency fund that covers 6-12 months of expenses. Also, there should be adequate life and health insurance cover.

“The individual should also check whether he or she is saving enough to for their goals. If individuals are lagging in their goals, it’s better to step up the monthly investments first,” said Pandya.

A better strategy is t use profits from your investment to prepay your home loan rather than a bonus or extra money you have saved out of your income. “The individual can use a portion of the profits to prepay the home loan instead of using the capital. Whether individuals use 10% or 50% of the profits is entirely up to them. The idea is not to use the capital,” said Kartik Jhaveri, director, Transcend Consultants.

Some experts believe that an individual should not prepay if the tax benefits available on a home loan is a significant portion of the income, and there’s time to retire. A person gets up to 1.5 lakh tax benefit on the principal portion of the home loan and up to 2 lakh on the interest portion. “If the tax saving is a significant portion of the income, it’s better not to prepay. The extra money in hand every year will give liquidity,” said Malhar Majumder, a Kolkata-based mutual fund distributor and partner, Positive Vibes.

He added, “It would make sense only to prepay when close to retirement and the person wants to finish all the liabilities”.

Also, before you make a decision, do evaluate if you have any significant expenses some months later. According to financial planners, people often prepay their loans with extra cash and later take a loan or swipe a credit card to meet a considerable expense a few months later.

(Do you have personal finance queries? Send them to [email protected] and get them answered by industry experts)

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