Deciding to invest a bonus or pre-pay a home loan depends on age, liquidity, risk appetite, loan tenure, tax benefits, psychology, and investment returns.
While new job’s bonus or performance bonuses or even an unplanned income from family members are usually a substantial one. Receipt of such substantial money can always create a dilemma of whether to invest the sum into SIP or pre-pay housing loan. In case of lack of housing loan, the answer is pretty much straight forward, however in case of existence of home loan, it can become a head scratcher. The answer to this dilemma differs from person to person, however the variable to determine the category could be same. Thus let us study what are these variable which decide the optimum outcome of this dilemma.
1. Age:
First and foremost, the age could be a huge determining factor, since it decides the earning capacity of an individual. So lets suppose you are in your mid thirties and occupied in a secured job, you can opt for lum sum investment subject to other variables. However if your age is in the later forties or early fifties, you may want to close home loan and reduce the liability before your income source extinguishes.
2. Liquidity or emergency fund:
An absolute must requirement in today’s date, but again having a home loan can cause serious hole in your personal financial planning, which indirectly deters creation of any sort of emergency fund or liquidity. Thus this surplus income can act as a stop gap solution, and help you create at least a temporary fund in case of emergency. However this option must be utilised given due respect to other variable covered in this topic.
3. Risk appetite:
Investing in mutual fund always carries a risk of stock market, therefore risk averse investors might not want to test the double sword of loss in mutual funds along with mountain of housing loan hanging on their head. In case of limited risk it is always appropriate to close the outstanding loans before going for investment in even moderately risky opportunities.
4. Tenure of investment:
When there are multiple loans such as car loan, personal loan or educational loan apart from the long outstanding housing loan, the surplus fund might be better utilised in closing one of these instead of pre-payment of housing loan. Since Housing loan is the cheapest amongst all loans, investors can sustain it for longer term. Even when there are no loan apart from housing but investor might need money for say renovation of house or wedding of children, then also these surplus fund could be utilised.
5. Income Tax:
Possibly the greatest pro against pre-payment of housing loan. Housing loan can help you upto 1.5 lakhs of allowable deduction for principle repayment and an additional up to Rs. 2 lakhs of benefit for interest repayment. Thus the aggregate tax benefit per borrower goes upto Rs. 3.5 Lakhs. Now if you are in 30% tax bracket, having gross income of Rs. 15 LPA, you will be saving Rs. 1,05,000 in tax. However since the limit of 1.5 lakhs under 80C is available through other options as well such as PPF, school fees, life insurance premium etc., the additional 2 lakhs for interest benefit could be the actual benefit.
6. Psychology:
With many risk averse investors do not like the burden of huge liability on their head. Lack of job security, single earning member, risky business nature or even lack of investment knowledge could lead the individuals to pre-pay home loan instead of investing in mutual fund. Even an absence of sufficient life cover coupled with sole source of income should opt for pre-payment of home loan. While some investors even though without any deteriorating conditions opt for pre-payment simply to retain sound sleep. Thus Psychology could play major deciding factor in the dilemma
7. Returns:
Possibly the climax in the dilemma, this variable gives the most practical answer amongst all. To put it simply, one should only opt for mutual fund over pre-payment of housing loan if the post-tax income from mutual fund is higher than effective cost of housing loan. Effective cost of housing is total EMIs of housing loan reduced by tax saving subject to the tax slab of every individual. To see it through a macro perspective, an outstanding loan of Rs. 70 lakhs at 9.5% interest brings to Rs. 6.65 lakhs now after deducting the 2 lakhs benefit of interest repayment it comes down to 4.65 lakhs. So a 4.65 lakhs interest on 70 lakhs loan gives effective interest of about 8.64% even to 30 tax bracket personnel. In addition to that these figures could change if the loan is joint and both can enjoy the 2 lakhs tax benefit. However if the total loan outstanding goes below 20lakhs then you may not be able to fully utilise the 2 lakhs interest benefit, since the maximum interest paid in the whole year will be less than 2 lakhs. In such case it is not advisable to pre-pay the loan and instead opt for mutual fund.
To conclude the answers to the dilemma could vary from person to person given the state of his or her age, risk apetite, emergency fund or liquidity requirement and lots more. However it may be wise to evaluate each variables and then decide the factor.
Comments