Is it better to Prepay Home Loan or Invest?

As someone who knows very little about home loans, the popularity of the titular question never fails to surprise me.

When this question was asked again in the face book group, Asan Ideas for Wealth (AIFW), I learnt something new. Here is an account of my understanding. I thank the members of AIFW for their insight.

Sometime back, on Subras request, Is it better to prepay home loan or invest for retirement calculator and realized that unless one wishes to retire early, there is no flaming hurry to pre-close a loan.

First let look at this issue from both angles

Invest and let the loan run its course

1.      After all, salaries will increase and inflation, which is comparable to home loan rate, will slowly, but surely diminish the value of the EMI.

2.      There are more obvious incentives to continue the loan. Even if there is no tax benefit from the principal component, since 80C is maxed out for most, the interest component is eligible for a decent tax deduction. The tax save can make a difference if invested

3.      Since the interest component is high for the first half of the loan duration, it makes sense to let the loan run at least for half the stipulated period and then pre-pay it.

4.      Is it better to prepay home loan due to investing now we will maximize the effect of compounding. What if you cannot build a large enough corpus for retirement or fund other goals?

 Notice that all arguments are mathematical in nature.

Prepay, close out the loan asap and then invest

1.      Why be in debt? Feels like a sword hanging over the neck. I can’t think clearly. My parents are urging me to get out asap.

2.      Why not actually own the home asap and then invest?

3.      What if interest rates increase? I have a high enough emi as it is!

 Is the 3rd argument the only mathematical one?

·         Let us now look at an imaginary but typical scenario.

·         Akash is a 30 year old, married and with a 2 year old daughter.

·         Gross annual income ~ 15.4 Lakhs. Annual growth 10%

·         Monthly expenses ~ Rs. 40,000; Inflation 8%

·         Home loan (self-occupied): 60 Lakhs; Rate: 10%; Tenure 20 year; EMI: Rs. 57,901;

·         Retirement 30 years away

·         Daughter education 16 years away

·         Daughters marriage 23 years away

·         Section 80C limit: 1 Lakh  (home loan principle is assumed to be not part of deduction)

·         Section 24(b) limit (home loan interest deduction): Rs. 1, 50,000

Akash has now obtained a lump sum of Rs. 3 lakh. Should he invest it or use it for pre-paying?

For both scenarios, we assume that

·         Akash invests his salary after accounting for expenses, EMI, 80C deductions, tax. The tax saved from section 24(b) is also invested.

·         Akash continues such investing after the end of the loan up to retirement

·         The investment is assumed to grow each year at the average rate of 10% and when the need arises –daughters education 16 years later; wedding 23 years later – redemptions are made from the same account.

·         Only long term goals are considered.

Which is better? Investing or prepaying?

Have a look and judge for yourselves. I am automating this Excel sheet so that inputs can be varied at will.

If the lump sum was pre-paid, Aksash will fall short of the corpus required for financial independence. Please don’t argue, not by much! Remember the numbers used here are imaginary. Until you punch in your own numbers, you will not know for sure.

Had he invested the lump sum, he would have got a corpus much higher than that required.

Had Akash, postponed the purchased of the house, would have done much better? Perhaps - shall include this option in the calculator to find out.

So which is better?

If we look only at the graph, investing the lump sum is better.

Not because he will fall short of the retirement corpus needed, but because it is not practical to assume that future cash inflows will be used for investing! We cannot be so sure about the future.

When you have money, invest – right now! Do not assume you will invest from your higher salary 5 years later. That may happen may not happen. Investing now, will get time on your side.

 Prepaying is not terrible!

Frequent prepaying makes sense only when the EMI is very large – more than 50% of net take-home pay.  In such a case the person will feel stifled and it makes sense to at least shorten the suffering. So pre-paying in chunks, every few months does have an appeal.

When our salary is accounted for completely by EMI, expenses and taxes, we cannot

·         Refill our emergency fund if it is used!

·         Handle unexpected recurring expenses

So even this suggestion is mathematical and not just governed by emotions. So even the sword above our neck feeling is grounded in math for those with high EMIs!

{Source: https://freefincal.com/prepay-home-loan-or-invest/}

Finding Your Ideal Home Loan: Fixed vs. Floating

With the official cash rate having decreased five times over the past 12 months (with the most recent 25 basis point move being in March 2016) many mortgage-holders are no doubt weighing up their fixed versus floating home loan options.

First up, we should say that the decision to choose between a floating or fixed interest rate loans when borrowing should be made according to your own individual situation and not necessarily just because that’s what everyone else is doing! We can, however, give you a few pros and cons to think about when you’re making your decision about home loan types.

What do you need to weigh up with fixed/floating home loans?

You need to weigh up whether you want to take advantage of rate fluctuations by floating your mortgage, or whether you need certainty of monthly repayments. Fixing your home loan rate means you know exactly what you have to pay every month and there are no nasty surprises if rates go up in the meantime. This gives peace of mind to those on a fixed income who may have some difficulty stumping up extra cash at the whim of their lender.

Floating, on the other hand, allows you to play the market more. If rates go down, so do your repayments. However, the opposite is also true. Here are some pros and cons of each – and you can compare home loans here.

Fixed home loans might suit a tight budget

Which home loan is best fixed or floating are certainly popular in New Zealand, with approximately 78% of visitors to CANSTAR’s home loan selector tables searching for a fixed-rate loan. This is not surprising, with current average fixed-rate loans on CANSTAR’s database cheaper across all loan terms than the average floating rate.

Possible benefits of a fixed-rate home loan

·        You know exactly what your repayments are until the end of the fixed term, which can be useful for those on a tight budget.

·        Currently, as mentioned, the average fixed rate home loan interest rates are lower than the average floating rate home loan interest rate.

·        If you are on a fixed rate home loan contract and the official cash rate rises, your repayments will stay the same.

Possible disadvantages of a fixed-rate home loan

·        If the RBNZ decides to cut the official cash rate –and if banks follow suit by cutting the interest rate of home loan products, you won’t get the immediate benefit of it.

·        Break fees on fixed-rate home loans can be hefty if you sell or want to get out of the loan before the fixed term is up.

·        When the fixed term is up you may have to revert to a higher rate in accordance with rate movements at the time – make sure you factor this into your budget

Floating: a home loan for playing the market        

Which home loan is best fixed or floating, plenty of people still float their home loan rate.

Possible benefits of a floating rate home loan

·        Sticking to a floating rate home loan gives you the ability to capitalize on any downward rate movements.

·        If rates go down so do your repayments, allowing you to pay more into your loan. There is a lot of money to be saved over the long term by keeping your repayments at the same level even as interest rates head down!

·        It’s flexible: if you want to refinance, move house or exit your home loan contract for any other reason, you can!

Possible disadvantages of a floating rate home loan

·        If rates go up you have to find money for higher repayments. This might be challenging if you are on a tight budget.

·        If the official cash rate starts increasing rapidly, you may find that it’s too late to lock in a favorable fixed home loan rate.

But, when it really comes down to it, choosing a home loan is about finding the right fit for you. After all, that knitted jumper might look absolutely smashing on your Nana but a frightful fashion crime when you try it on for size.

A home loan is a long-term prospect, so take the time to compare home loan rates, look at your own finance and budgeting style and talk to any significant others if they are involved in the process.

{Source: http://www.canstar.co.nz/home-loans/should-you-fix-or-float-your-home-loan/}

What is Home Loan pre-payment?

What is Home Loan prepayment?

Pre-payment is early loan repayment. Prepayment is an EMI installment payment before its due date and is usually a big amount. If you have a large sum of money, then you can pay this amount back to repay part of your loan. This results in either a reduction in the EMIs for the remaining tenure or reduction in tenure with the same EMI. The prepayment amount must be at least three times your EMI.

What is Home Loan part pre-payment calculator?

Part pre-payment calculator is a calculator that shows the positive impact of an early repayment of your loan.

How to use Home Loan part pre-payment calculator?

All you need to do is simply enter your loan details and then enter the amount you wish to pre-pay. Do keep in mind that this amount will have to be minimum three times the calculated EMI.

You can move the sliders to your left or right to adjust the values or you can directly type the values for the following:

The Loan Amount

Tenor (In Months)

Rate of Interest

The part pre-payment amount that you wish to pay

After you enter these details, click on “Done”. You will be able to see two options.

EMI Saved: This table shows the reduction in your EMI and monthly savings in EMI post part pre-payment

Tenor Saved: This table shows the reduction in your tenor post part pre-payment

Home Loan Prepayment Benefits

How a Home Loan part pre-payment calculator works?

The part pre-payment calculator works on four main variables:

The Loan amount

Tenor in months

Rate of interest

Pre-payment Amount

{Source: https://www.bajajfinserv.in/finance/home-loan/home-loan-part-pre-payment-calculator.aspx}