Financial decisions tend to leave people scratching their heads, and even worse when there is a string of options available. In the era of easy home loans and the rising equity market, one would be confused about buying a house, home loan prepayment, or investing in equity funds. This is where the question arises if you have additional or excess liquid cash, should you prepay an existing loan or invest in mutual funds?
Although financial common sense would tell you to repay your loan first, it is not that simple. To answer this question, you need to consider a few aspects of both of these to avoid financial mishaps.
Home loan interest rate
Prepaying a home loan would save the interest which you would have to pay with your EMI. Whereas, opting for mutual funds would heighten the risks associated with fixed interest rates loans in a falling interest rate environment (on-going economic conditions due to high-interest liability).
Effectively saving the home loan interest which you would be paying with your EMI is handled if prepayment is done and they are considered for tax benefits under Section 80C up to Rs. 1.5 lakhs. Additionally, an exemption of up to Rs. 2 lakhs on your interest payments annually under Section 24 is available if you invest in mutual funds. Either way, the choice about which tax benefit is more appropriate has to be made.
A prepayment penalty is charged by lenders in case the borrowers pay off or pay down the loan (more than 2-3% of the outstanding loan amount) before its term, making it difficult to refinance loans for a few years after taking out a loan.
Prepayment of a loan can cost a huge lump sum of money. To avoid monetary shortage during inevitable circumstances you have to make sure you have enough surplus after the prepayment for future emergencies.
Improving liquidity is facilitated by investing in debt funds than prepaying a loan. These include short-term and ultra-short-term schemes to help avail surplus funds. Changing your home loan into a super-saver or smart loan structure i.e. minimal or nil exit load and low expense ratio will hold spare funds in the loan account. It facilitates the reduction of the interest and offers liquidity at the same time with a rate of return comparable to that of the loan.
The returns from your investment are majorly dependant on the market conditions that can be highly volatile, causing increased risk and a period of negative returns.
Here, the opportunity cost by not pre-paying your loan brings in returns that one can earn by investing in debt or equity funds.
After in-depth consideration of the aforementioned factors, keeping in mind the psychological strain of having a home loan, you can decide which option will benefit your needs. This decision will vary from person to person concerning other personal aspects that are involved.