You may currently have a home loan. Suppose you had taken this loan five years ago and your income levels have increased since then.

Will you pay down your home loan using additional cash flow that you have due to increase in income levels? Or will you continue your loan and use the additional savings to invest in, say, equity? In this article, we discuss how you should decide between the two.

Prepayment factors

Suppose you pay Rs 40,000 a month as equated monthly instalments (EMI) on your home loan. Assume that your income levels went up,so you can now pay an additional Rs 10,000 a month. The question is: Should you prepay your home loan or should you invest the additional Rs 10,000 to build your investment portfolio? Suppose you pay 11 per cent interest on your home loan. The argument would be to prepay your loan because you may find it difficult to consistently generate 11 per cent return on your investments. Further, you may have less pressure on your lifestyle when your debts are paid off.

Your decision to prepay your loan is not always that easy. One, you have to check how much your bank will charge you as prepayment penalty.

You should deduct the penalty from the interest rate to arrive at your savings due to prepayment. And two, you need to check if inflation is likely to go up. Why? If inflation is high, you are better off borrowing today and repaying later; for Rs 10 lakh today will be worth more than Rs 10 lakh next year. By the same logic, prepaying today may not be attractive because you can use the money to invest in assets that move up with inflation- commodities, for instance. The question then is: When should you invest your additional savings?

You typically invest in equity if you expect to receive a higher return compared to that on bonds.

This higher expected return on equity is the compensation (risk premium) you demand for taking on higher risk.

Suppose you expect to receive 8 per cent return on bonds and 12 per cent on equity.

The returns-differential of 4 percentage points is the equity risk premium. The point is that when you are choosing between prepaying home loan and investing in equity, your risk premium is above the loan rate you are paying, not the interest rate on bonds!

Now, the equity risk premium is typically 5-6 per cent. Add the risk premium to your home loan rate of 11 per cent and your expected return on equity becomes 16-17 per cent. You should prepay your mortgage if you do not expect to consistently earn such return on your equity investments. But prepay your home loan after you have crafted a disciplined approach to savings and investment.

Because of your prepayment schedule, you will close your home loan earlier than its schedule date. Suppose your regular EMI is Rs 40,000 and you were scheduled to close the loan only in 2022. The prepayments could help you close your home loan in 2019. You should plan today to systematically invest Rs 40,000 a month between 2019 and 2022. Otherwise, you will most likely spend the additional cash from 2019!

Conclusion

There are indeed compelling arguments to prepay your home loan if you have surplus cash.

The alternative- continuing your mortgage and investing surplus cash in equity- can be argued as leveraged investments. That is, it is equivalent to you borrowing money to invest in equity! Further, prepaying home loan saves you interest cost while investing in equity does not fetch you a certain return every year.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can bereached at enhancek@gmail.com )

comment COMMENT NOW