Several individual specific factors determine whether to prepay one's home loan or use the surplus income to invest

 

If you have an outstanding home loan, and happen to have just re ceived an annual bonus or any other lump sum payment, should you use it to prepay your loan? Or, should you invest it to meet some other financial goals? Assess the following conditions to arrive at the right decision.

Some people may not be comfortable with a large housing loan and, to reduce their stress, they may want to get rid of the loan burden at the earliest. For them, settling the question of how to use their bonus is simple: just pay off the loan. You should pay off the loan for the house you live in at the earliest. Several unfortunate things--job loss, death of the earning member, serious illness, etc--can cause trouble during the 10-15 year loan period. Treat it as a mind game and not a numbers game.

Tax benefit is the next variable. If home loan does not seem like the sword of Damocles, hanging over your head, it makes sense to continue with the regular EMI schedule. This is because of the tax benefits that a home loan offers.

The principal component of the housing EMI is treated as investment under Section 80C of the Income-Tax Act. The interest component is also deducted from your taxable income under Section 24. The annual deduction in respect of the interest compo nent of a housing loan, for a self-occupied house, is limited to `2 lakh per annum.

You won't be able to claim deduction on interest paid above `2 lakh. So, if your annual interest outgo is higher han `2 lakh, it makes sense to prepay the loan, and save on future interest payment. For example, the annual interest on a `70 lakh outstanding home loan, at 9.5%, comes out to be `6.65 lakh.

After taking into account the `2 lakh deduction under Section 80C, the in terest component will fall to `4.65 lakh, and bring down the effective cost of interest from 9.5% to 6.65%, even for the people in 30% tax bracket, but you will still have to pay `4.65 lakh every year in interest.

You can, however, optimise the tax benefits if the loan has been taken jointly, say , with your spouse.

If joint holders share the EMIs, both can claim `2 lakh each in interest deduction. For joint holders, there is no need to prepay , if the outstanding is less than `40 lakh. Bear in mind, by prepaying your loan, you may also forego future tax benefits.

The third key variable is returns from investment of the lump sum at hand. As a thumb rule, you should go for investment, instead of prepayment, only when the post-tax return from the investment is likely to be higher than the effective cost of the housing loan.

For investors in the 30% income-tax bracket, and whose outstanding home loan balance is less than `20 lakh, the effective cost of loan is only 6.65%. Since there are several risk free, tax-free debt options such as PPF , Sukanya Samruddhi Yojana Account and listed tax-free bonds, which offer higher annualised return than this, it makes sense to invest in them. All the debt products mentioned above are long-duration products.