Should You Prepay Your Home Loan Or Invest In Mutual Funds Or FD

Simple mantra for home loans, prepay as early as possible. Only investment which is generating a very high return (home loan interest rate +5.5%) will earn extra return compared to saving from prepayment. 

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Everyone who has taken home loan has one very simple question; should I prepay my home loan or invest the saved money in mutual funds or bank FD? There is not a clear answer to this question. Based on scenarios the answer will change. In this article, I will try to answer home loan prepayment or invest saved money dilemma. 

I will take a look at historical mutual fund returns and the interest rate on FD and in what scenario, prepayment of home loan is beneficial and in which case investing saved money is beneficial.

Normally when somebody buys a house/flat, he/she gets financially stretched due to super high prices of real estate and high tax rate. (you can read about why taxes are very high on real estate in this article). He/ she has to arrange money to pay 20% down payment and around 10% taxes. Most of the time home buyer ends up penny less for a few months after paying down payment and taxes (personal experience). Only after a few months or a year or two, the home buyer starts saving again due to an increase in income. Now the homeowner is faced with the question of what to do with the money. 

Let’s see different scenarios and in which scenario, the homeowner will be better off in prepaying the home loan. (In this article, I have discussed the historical interest rate on FD and return on different Mutual funds.) based on the analysis presented in the article following information can be found:

The historical average interest rate on FD was 8.64% and only 27.13% mutual funds have given more than 8% return and only 5.17% mutual funds have given more than 10% return. Even you can do this analysis using excel template called loan amortization.

Basic details of home loan; a 40 lakhs home loan is taken in October 2018 at the interest rate of 9.5% for 20 years. Equated Monthly Installment (EMI) for this loan comes at Rs. 37, 285. The homeowner is paying EMI since then and paid 24 EMIs till now. As interest rate has fallen in the last two year, his/her home loan interest rate has also fallen to 8.85%. He/She has started saving again due to an increase in income. He looks for investment opportunities like FD/PPF, mutual funds.

If the homeowner prepays an amount equal to one EMI every quarter from now till home loan ends; he/she will save an amount equal to Rs. 1,533,281 or more than Rs 15 lakhs (Check computation in Scenario 2). 

If he/she invests the same amount in any other financial instrument like FD, PPF or Mutual Fund, he/she will get more return only when the rate of return is around 14% or more (Check computation in section return comparison).

Simple mantra for home loans, prepay as early as possible. Only investment which is generating a very high return (home loan interest rate +5.5%) will earn extra return compared to saving from prepayment. 

Computation and Analysis

Home Loan Details

Scenario 1: No Prepayment

Scenario 2: Every Quarter Prepayment of an Amount Equal to EMI

Saving = Total Payment without prepayment - Total Payment with prepayment

1533281 = 8,177,776 - 6,644,494

If the homeowner every quarter does a prepayment of an amount equal to EMI, the homeowner will save 15.33 lakhs rupee in interest payment.  

Return Comparison

The table below shows the different investment return for different expected return per cent and what is beneficial prepayment or investment.

From the above table, one can understand investment is beneficial only if the annual return from investment is around 14% or above. 

Even prepayment of one EMI in the first year of loan tenure can have a huge impact on the total amount paid for the home loan. In the current example, if the homeowner had paid one EMI in the first 6 months of loan tenure he could have easily saved 1.90 lakh.

Simple mantra for a home loan, prepay as early as possible. Only investment which is generating a very high return (home loan interest rate +5.5%) will earn extra return compared to saving from prepayment.