How to make most of the annual bonus: Save 56% more if you invest Rs 2 lakh in equity mutual fund than prepaying home loans

This is a very special time of the year for many salaried people as they would get their highly awaited annual performance bonus or incentives and would be planning the best way to use it. If you have an outstanding home loan, there can be a dilemma between using this money to make a partial loan repayment and investing it. We tell you which option is better for you and how you should take a call about deploying your hard-earned annual bonus.

How does partial prepayment of home loan help?

Most people are uncomfortable with their financial position if they have a loan, especially a long-term debt burden like a home loan. They prefer to become debt-free at the earliest and so go for prepayment whenever possible. “Home loan prepayment will save you money on interest payments and shorten your loan tenure. It reduces the debt and interest burden,” says Sanjeev Govila, CEO of Hum Fauji Initiatives, a financial advisory firm. “Consider this option if you prefer low financial risk and debt-free living. Prepaying of a home loan also has a psychologically positive effect, which cannot be evaluated in money terms, especially if the EMIs have been causing financial stress in the family.”

So it might look sensible to use the annual bonus or incentives to reduce this debt. But is that the best option for everyone with a home loan or does it pay to invest that money? . “It is always better to be debt-free, hence one can consider reducing the home loan if they are in the first 10 years of their loan. This will help them save a substantial amount on the interest. But someone who just has a couple of years of loan repayment left should think of investing the bonus or incentive, instead of repaying the loan,” says Harshad Chetanwala, founder, My Wealth Growth, a wealth management firm based in Mumbai.

How much you can save: Prepaying home loan versus investing in equity mutual fund

Assumptions: Home loan outstanding Rs 40 lakh, Remaining Tenure 20 years, Interest Rate 9.00%pa, EMI Rs 35989, MF returns 12% pa. *As tenure comes down if you prepay and keep paying the same EMI, when your loan is paid off early you can invest the remaining saved EMIs monthly in equity MF SIPs during remaining part of orginal loan tenure.

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When should you consider investing in equity mutual fund instead of prepaying home loan?

Some might not mind having a debt for a while if they can create additional wealth with the surplus money they have. In such a situation, compare both the options — prepaying home loan and investing — and go for the one that gives you a higher net advantage.

“Prepaying your home loan can lead to significant interest savings over the loan tenure, which is typically 15-20 years, reducing the overall cost of borrowing. However, equity mutual funds, especially over the long term, have historically offered higher returns compared to the interest saved from prepaying a home loan,” says Adhil Shetty, CEO of Bankbazaar.com.

If you are not comfortable with outstanding debt, use the annual bonus to prepay a part of your home loan — which should reduce the loan tenure or reduce the EMI — but keep paying the same EMI amount so that your home loan is paid off earlier. Also, as your EMI payment period would reduce, you can then build your corpus by investing an amount equal to the EMI every month in an equity MF via the systematic investment plan (SIP) route during the remaining period of original tenure .

A monthly SIP investment into NIFTY50 TRI Index would have given a CAGR return of 18.59% in the last 5 years, 14.88% in the last 10 years, 13.77% in the last 15 years — the calculations are for periods ended April 30, 2024.

Consider this: If you have an outstanding home loan of Rs 40 lakh at an interest rate of 9% and a balance tenure of 20 year, you can save Rs 8.77 lakh in interest payment by making a partial prepayment of Rs 2 lakh today, and your loan would be paid off 30 months earlier than the original tenure of 20 years. However, for a fair comparison with investment alternatives, we need to utilise the saved EMIs and the remaining loan period. So, if you invest the remaining EMIs monthly in an equity MF as SIP, it would grow to Rs 18.83 lakh, if it earns an annual return of 12%.

If you are not uncomfortable with debt, explore equity investment options by investing the surplus into equity MF instead of prepaying your home loan. If you decide on this route, your Rs 2 lakh could grow to Rs 19.29 in 20 years, if your returns are around 12%. So, investing in equity MF instead of prepaying the loan would have saved you Rs 7.67 lakh more, or a whopping 65.93%.

Investing in equity MF comes with the risk of uncertainty

You can earn higher returns by investing in the equity market, but it is not a certainty. “Investing in equity mutual funds has the potential for higher returns but also comes with higher risk. Consider your risk tolerance and investment horizon here. It is suitable for those with a longer investment horizon and higher risk tolerance,” says Govila, also a Certified Financial Planner. However, if your investment horizon is long term — say over 10 years — the chances of earning good returns are higher. “Finally, the answer lies in evaluating one’s own personal financial goals, risk tolerance, and existing debt levels before deciding,” suggests Govila.

He says it is important to consider the risk in equity investment as equities can be volatile in the short-term. Even in the longer term, there is no guarantee of higher returns as it depends on a lot of factors that are largely outside a person’s control. “Consulting a financial advisor can help you decide if this is the right option for you,” says Govila.

A lower return can change the dynamics in the favour of loan prepayment. If the returns from your MF investment are 10%, your net advantage in investing in equity MF could come down to just Rs 1.09 lakh. If the returns are lower, loan prepayment would be a much better option.

In case you are not in favour of going for only one option, you can choose both. “You can allocate a portion of your funds to prepaying your home loan and a portion to investing in mutual funds, to balance risk and return potential,” says Shetty.

Don’t forget to factor in tax benefit offered by home loan repayment

While doing the comparison, factor in income tax implications as well. Home loan repayment qualifies for income tax saving both on interest payment and principal repayment. While going for equity MF investment would mean that you would end up paying 10% long-term capital gain on your gains over Rs 1 lakh.

Here the income tax bracket of the individual will also be a deciding factor. People in the higher income tax brackets will save more tax by continuing their home loan. “For those in the highest tax bracket, investing in equities can offer better long-term returns compared to the after-tax cost of the home loan,” says Govila.

However, when you are paying a much higher annual interest than the maximum exemption of Rs 2 lakh, it would be better to prepay your home loan. “In today’s times considering the cost of residential properties in many cities, the interest component is a reasonable amount in the overall loan repayment. Hence, many times we see the limit of Rs 2 lakh on which the tax benefit is available easily getting crossed. There will still be a good amount of interest one pays over and above this limit. In such cases, repaying the partial loan is still a good option. Another important point to note is that the interest charged is a fixed rate whereas the returns from equity investments vary across the period,” says Chetanwala.

Should people in lower income tax bracket prefer to prepay in absence of significant tax saving from home loan?

In case you are not getting a significant benefit in terms of income tax saving, loan prepayment may be a better option if you prefer being debt-free soon. “Prepayment is surely beneficial for those with minimal tax benefits from home loans since it reduces long-term interest payments and speeds up the path to becoming debt-free. However, one may also consider other debt repayment priorities or investing for one’s own future goals since a home loan generally costs lower than other loans even if the tax benefits are minimal,” says Govila.

While prepayment may work better, the final call should be on the basis of your cash flow. “Irrespective of the tax bracket, it is better to reduce the liabilities. At the same time, one must consider their monthly cash flows in mind. Sometimes, if the monthly cash flow is too tight, investing or saving the money instead of repaying may work better,” says Chetanwala.

Should people who are close to their retirement prefer prepayment?

Prepaying a home loan could be more advisable when you are approaching your retirement. “Paying off a home loan before retirement can reduce your overall debt burden, leading to lower monthly expenses after retirement. This can provide peace of mind and reduce the need for a higher retirement corpus to cover loan payments. It will also help you claim full ownership of your property as you can use it to borrow funds at any time,” says Shetty.

“Without any doubt, it’s advisable to reduce liabilities when one is approaching retirement. Prepayment of loan can secure a more stable financial future and take-off a part of the real or perceived financial stress,” advises Govila. “But this also has to be seen against the need for ready access to cash; prepaying the loan reduces one’s liquidity. Speaking to a good financial advisor at this critical juncture will always help.”

Chetanwala says, “Having a loan when around retirement is not the best option and hence repaying or reducing the loan with the help of a bonus or incentive should be a good idea. This will help them to come out of the liability before \schedule and, most importantly, offer them peace of mind as they become debt-free earlier.”