The Indian middle class prefers to buy a home early in their professional life, with a home usually being the biggest investment for most Indian households. The initial excitement of owning a home for an average salaried person can be dampened when she finds herself paying a large portion of her income in EMIs. When an annual bonus is received, there is a temptation to use it to prepay your home loan partially and reduce your EMI. Is this the right decision?
There are multiple ways of approaching this problem and it is a highly personal decision – however there are some guidelines you can use to decide this.
The easiest case is when your EMIs are comfortable and you have some ideas on how you would invest the money. Most long-term investments usually deliver returns much more than the home loan rate, so you would be much better off keeping the home loan and investing your bonus. ie. If your home loan rate is 7.5% and your long-term investment in mutual funds can generate 12% return, it is an easy decision to invest the money rather than prepay the loan.
On the opposite end, if you’re finding the EMIs challenging and you prefer to be debt-free faster, you can prepay the home loan partially if you have already taken care of basics like an emergency fund. For floating rate home loans, there are no prepayment penalties and for fixed rate loans, there may be a prepayment penalty of around 2% (varies from bank to bank).
While prepaying a home loan, we should keep in mind the tax benefits on home loan interest & principal payments as well. The interest portion of the EMI paid for the year can be claimed as a deduction from your total income up to a maximum of Rs 2 lakh (for self-occupied property) and no limit (for rented out property) under Section 24. This is a unique benefit for home loans, so you should make sure you calculate the trade-off between comfort/peace of mind from lower EMIs and the lower tax benefit that will be available to you.
Separately, the principal portion of the EMI paid for the year is allowed as a deduction up to 1.5 lakhs under Section 80C, but this can be easily replaced by any other investment such as PPF or ELSS.
There is one more factor people ignore while making this decision – usually the EMI saved through prepayment is not used to invest more for the future – it may just be used for higher living expenses or just lie idle in your bank account. Some people find it easier to save when there is the discipline of a high fixed monthly EMI. One way to deal with this issue is to prepay the loan but ensure that you immediately set up a recurring investment (SIP) in a good long-term investment for the amount you have reduced from your EMI.
