Home loan prepayment vs investing: When should you use extra cash to repay debt?

Most home loan borrowers aspire to reduce their overall debt. This is done either by making larger EMI repayments or by making strategic prepayments. That is why, when such individuals receive a salary bonus, increment, or annual incentive, a key financial question always arises: Should the money be utilised to reduce the outstanding loan or invested elsewhere, potentially for generating higher returns? For example, in equities, mutual funds or other similar asset classes that can beat inflation and help in growth?

The answer to such questions is not straightforward. It entails many vital aspects that must be considered holistically. For instance, the interest rate on a home loan, expected investment return, level of risk involved, possibility of capital depreciation, applicable taxes, and the borrower’s liquidity requirements.

Keeping these important aspects in mind, let us see what a home loan prepayment is and how it can be utilised by home loan borrowers.

What is a home loan prepayment?

Atul Monga, CEO & Co-Founder, BASIC Home Loan, explains, “Home loan prepayment means using surplus funds to reduce the outstanding principal, thereby lowering the interest burden. Whether prepayment is better than investing the surplus money depends on the borrowing cost versus the post-tax returns that the funds can generate elsewhere. If the surplus funds are earning less than the borrowing cost and the borrower is still early in the loan cycle, prepayment can be a better option.”

Why early prepayment can reduce your interest burden

As a matter of rule, every borrower should focus on becoming debt-free as soon as possible. This applies to all types of loans, including home, personal, and car loans. Now, be clear, when you prepay your home loan earlier in the repayment tenure, it can have a meaningful impact on your overall borrowing costs and financial health. This is because interest is calculated on the outstanding principal.

When you focus on reducing the principal in the initial years, it can help lower the interest payable over the remaining tenure. Borrowers can also opt for prepayment to reduce the loan tenure or lower their equated monthly instalments (EMIs), depending on their long-term family responsibilities and economic objectives.

Balance prepayment with liquidity and investment returns

This is yet another important aspect that demands due consideration. As a borrower, one must focus on maintaining a proper balance between prepayments and liquidity. This means not delaying prepayment for too long and simultaneously managing it so one doesn’t face a serious fund crunch due to a home loan prepayment decision.

When an individual uses all surplus cash for loan repayment, it can easily stretch them and leave them with inadequate liquidity for meeting unforeseen emergencies or other financial objectives. Monga explains this aspect in detail, stating, “Borrowers should also consider the liquidity of their funds and the tax implications. A full or partial prepayment can be more beneficial when made earlier in the loan cycle, as it reduces the principal on which future interest is calculated. For floating-rate home loans, banks cannot charge foreclosure or prepayment penalties under RBI rules. However, borrowers should still check their specific loan terms, particularly in the case of fixed-rate or other loan structures.”

Eventually, the decision of making home loan prepayments or investing the funds in growth assets for wealth creation should be based on the borrower’s current economic situation, family responsibilities and future financial goals.

This is certainly not a decision of simply opting between debt repayment and investment, as it entails several other critical aspects that deserve proper due diligence. Having a well-planned emergency fund is also a prudent step before making a large prepayment.

Once that cushion is in place, borrowers can compare the post-tax returns they expect from an investment with the effective cost of their home loan. If the investment is unlikely to generate returns higher than the borrowing cost, particularly during the early years of the loan, prepayment can be a sensible way to reduce future interest outgo. Still, any final decision on these aspects must be made after proper analysis and professional guidance from a certified financial advisor.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. Home-loan and investment decisions should be based on individual circumstances, risk appetite, tax implications and financial goals. Consult a qualified financial adviser before making any decision.