We all know and agree that earning money is hard, isn't it? After all, earning our bread and butter and living a happy and comfortable life is what we all work hard for every day. But an equally hard task is to smartly manage the money earned.?
And often in life, we are faced with the dilemma of how to utilize our surplus money. Whether you got it through annual appraisal or festive bonus from your employer or some of your previous investment matured, having surplus money in hand can be a challenging situation to be in.
Some of you might want to splurge on an expensive gadget or go on a trip, whereas some may prefer to put it to best use financially. If you are part of the latter group, wealth creation by investing your money should be your prime goal to maximize this opportunity of having a surplus.
However, at the same time, if you are repaying your home loan EMIs as well, then the situation can be a tricky one. For existing home loan borrowers, having surplus funds is both a joy as well as a dilemma, isn't it? Whether to invest your surplus money for wealth creation or make home loan prepayment with it to reduce the interest cost is the decision you need to take.?So let’s help you out by comparing the two decisions in simplified mathematical terms.
Let’s assume you have a surplus of ?1 lakh and have a home loan of Rs 50 lakh, taken for a tenure of 20 years, at an 8% p.a. interest rate.? Your EMI comes to ?41,822. The interest cost you save by making partial prepayment would depend on your residual tenure of home loan.?
The earlier you prepay, the higher your overall interest cost savings are. On the other hand, the later you prepay, the lower your savings in interest cost would be, as home loan borrowers tend to have already paid the major chunk of interest cost in the initial years of the tenure itself.
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Let's take a few year tenures as examples to help you get a fair idea of savings through prepayment during the 20-year tenure of a home loan.
-If you prepay upon completion of 2 years of tenure (i.e. paid 24 EMI instalments already), making prepayment of ?1 lakh that you have as surplus would result in total interest cost savings of close to ?3.13 lakh.
-If you prepay upon completion of 5 years of tenure (i.e. paid 60 EMI instalments already), making prepayment of ?1 lakh that you have as surplus would result in total interest cost savings of close to ?2.28 lakh.
-If you prepay upon completion of 10 years of tenure (i.e. paid 120 EMI instalments already), making prepayment of ?1 lakh that you have as surplus would result in total interest cost savings of close to ?1.15 lakh.
-If you prepay upon completion of 15 years of tenure (i.e. paid 180 EMI instalments already), making prepayment of ?1 lakh that you have as surplus would result in total interest cost savings of close to ?51,000 only.
So, as visible from these examples and calculations, the earlier you prepay, the higher your overall savings in interest cost are.
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Now, on the other hand, let's have a look at how much you accumulate on investing that surplus money in different?investment options like equity and debt mutual funds, and bank FD, for varying tenures.
Let's take the category average returns of some of the mutual fund categories of equity mutual funds and debt funds. (Data as per returns on 29.12.2021 for direct plans, sourced from valueresearch)
1 year-26.59% (? lakh invested will become ? 1,26,590)
3 year-17.29%(? lakh invested will become ? 1,61,355)
5 year-16.72%(? lakh invested will become ? 2,16,634)
7 year-12.38%(? lakh invested will become ? 2,26,372)
1 year-45.57%(? lakh invested will become ? 1,45,570)
3 year-23.64%(? lakh invested will become ? 1,89,007)
5 year-19.32%(? lakh invested will become ? 2,41,861)
7 year-15.93%(? lakh invested will become ? 2,81,430)
1 year-4.82%(? lakh invested will become ? 1,04,820)
3 year-6.84%(? lakh invested will become ? 1,21,956)
5 year-6.74%(? lakh invested will become ? 1,38,559)
7 year-7.56%(? lakh invested will become ? 1,66,554)
1 year-3.35%(? lakh invested will become ? 1,033,50)
3 year-4.71%(? lakh invested will become ? 1,14,806)
5 year-5.58%(? lakh invested will become ?1,31,192)
7 year-6.27%(? lakh invested will become ?1,53,065)
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(Bank FD rates of the relatively bigger banks are currently ranging around 2.5%-5.75%, whereas Small Finance Banks have been offering in the range of 2.9%-7% p.a. for varying tenures)
Let's take two cases to give you a fair idea of how much your ? 1 lakh will get accumulated, through FDs in the present rate scenario (all assumed at quarter interest payout)
Assuming an interest rate of 5%?
Tenure of FD-1 year: ?1.05 lakh
Tenure of FD-3 year: ?1.16 lakh
Tenure of FD-5 year: ?1.28 lakh
Tenure of FD-10 year: ?1.64 lakh
Assuming an interest rate of 7%?
Tenure of FD-1 year: ?1.07 lakh
Tenure of FD-3 year: ?1.23 lakh
Tenure of FD-5 year: ?1.41 lakh
Tenure of FD-10 year: ?2 lakh
Also Read: Debt Funds vs FD - Which Is The Best Investment Option?
Going back to our example taken for the prepayment scenario, if you are in initial years of up to 2-5 years of tenure, you are saving interest cost of up to? ?2.28 lakh-?3.13 lakh upon prepayment. Whereas at that stage if you invest in the stated debt fund categories or bank FDs, you are expected to get up to ?1,53,065-? 1,66,554 and ?1.64 lakh- ?2 lakh as returns, respectively. So, prepaying would make sense instead of going for investing in these low return options at present according to the assumed example, as overall savings in interest cost when done in initial tenures of up to 2-5 years is higher than the returns you get through these investments.
As far as equity funds are concerned, they tend to offer higher returns of up to ? 2,26,372-? 2,81,430, which is higher than the interest savings if prepaid after 5 years, but lower than the savings on interest cost when prepaid at 2 years of the home loan tenure.
And for those currently in their later tenures like 10 years or 15 years, which derive lower savings of up to ?51,000- 1.15 lakh only, it would be prudent to invest your surplus as these investment options are expected to fetch higher returns than the savings you would otherwise get on prepaying in the later stage of home loan.
While there’s no right or wrong answer here, given that both these options have their respective pros and cons and varying suitability depending on one’s risk appetite, financial position, investment horizons etc., let's understand it in simpler words.?
For that ?1 lakh surplus that you have, your decision to invest or prepay a home loan should ideally depend on the comparison of how much you are saving in terms of interest cost upon prepayment v/s the returns you will fetch, i.e. the wealth you will accumulate through investment.??
More often than not, prepaying would be a smart option if you are in the initial stages of your home loan tenure and are looking to save on overall interest costs. Whereas in case either you are in the latter stages of a home loan or wish to completely put your surplus towards the motive of wealth creation, investing would be the smarter choice. But nevertheless, it's prudent to do the math and then arrive at the appropriate decision.
If you are in the initial stages of a home loan and opt for the prepayment option, remember to factor in the applicable prepayment charges, if any. Although as per RBI guidelines, banks and HFCs are barred from levying prepayment penalties on floating rate home loans, some lenders may levy prepayment charges of around 1%-2% on fixed-rate home loans. So, make sure that in the presence of prepayment charges, go ahead with prepayment only if the overall savings in interest cost significantly outweigh such associated costs/charges if any.
While bank FDs have been a favourite for risk-averse investors for several decades, remember that not only are the returns on the lower side, especially currently during falling interest rate regime in the economy, but even their post-tax returns are low. Click here to know more. As far as market-linked investments like mutual funds are concerned, remember that these returns depict historical performances of these respective mutual fund categories. Before investing, make sure to factor in your risk appetite, investment horizon and financial goals to maximize the benefits of these investment instruments for wealth creation. Click here to read more about mutual funds.
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