Should you prepay your home loan or invest the money?

Few questions in Indian personal finance get argued about as much as this one. Most of the disagreement comes from comparing a known number with a hopeful one. You know your loan rate for certain, while an expected return is only an estimate, and treating the two as equivalent leads to the wrong conclusion.

Clear expensive debt first

Before you think about the home loan, look at your other borrowing. Credit card balances you roll over in India typically cost 3 to 4% a month, which compounds to roughly 40 to 50% a year. Personal loans usually charge somewhere in the teens. No investment is likely to beat that consistently, and while the card's interest is certain, the portfolio's return is not.

If you have either kind of debt, pay it off before deciding anything about prepaying or investing. The home loan question comes after that.

Comparing the two options

Prepaying a home loan gives you a certain, tax-free return equal to the loan's interest rate. If you pay 8.5%, each rupee you prepay earns 8.5%, with no volatility and no tax on the gain.

Investing gives you an uncertain return, and you pay capital gains tax on it. Suppose you expect 12%. If you get it, that works out to roughly 10 to 10.5% after tax, and over any given ten-year window you may not get it. So you are weighing 8.5%, certain and tax-free, against about 10 to 10.5% that depends on the markets.

Investing can come out ahead, but the gap is much smaller than it first looks, and it is what you are paid for taking on risk. Run your own numbers with the EMI calculator for the prepayment side and the SIP calculator for the investing side.

Your tax regime affects the answer

Under the old regime, interest on a home loan for a self-occupied property is deductible up to a limit. That lowers the effective rate you pay and tilts the maths towards investing. Under the new regime you cannot claim that deduction on a self-occupied property, so you pay the full rate and prepaying looks better.

Check which regime you are in before you decide. The income tax calculator compares both side by side for your income. Many people assume they are claiming a deduction that they are not.

Timing matters more than people expect

EMIs are front-loaded with interest. In the early years, most of each payment goes to interest and very little to principal. That is why a prepayment early in the tenure removes far more total interest than the same amount paid later.

On a twenty-year loan, a prepayment in year three can take several years off your payments. The same amount in year fifteen takes off months. If you are late in the tenure, prepaying makes much less sense and investing makes more.

Shorten the tenure instead of lowering the EMI

When you prepay, most lenders ask whether you want to keep the EMI and shorten the tenure, or keep the tenure and lower the EMI. Nearly all the interest saving comes from shortening the tenure. A lower EMI eases your monthly outflow, but you give up most of the benefit.

What the spreadsheet leaves out

Two factors are missing from the calculation, and they often point to the right decision.

• Liquidity. Once money goes into the loan, you cannot take it back out without borrowing again, usually at a higher rate. Never prepay from your emergency buffer.
• Sleep. Some people are comfortable carrying debt and some are not. If the loan keeps you awake at 2am, paying it off early is a reasonable choice even when a spreadsheet favours investing by a percentage point.

A sensible order

1. Clear credit cards and personal loans.
2. Fund the emergency buffer.
3. Capture any employer retirement match and essential insurance.
4. Then divide spare money between prepayment and investing instead of picking just one.

Splitting gets less credit than it deserves. Nobody knows how markets will do over the life of your loan, and a split keeps you from putting everything into the option that turns out worse.

How this affects your Health Score

Debt is scored as its own pillar in your Financial Health Score. Whether a loan helps or hurts you depends on its rate and what it paid for. A home loan at a reasonable rate and a revolving card balance are very different, and a single "total debt" figure would hide that.