Investment in gold and equities is an option, but the risk-averse should go for part-prepayment.
Most borrowers who took a loan in recent years have been forced to fork out higher equated monthly instalments (EMIs). Or, if they have age on their side, tenures have been increased. For some, it has been a double whammy of both EMI and tenure rises.
With reducing the debt burden being the primary objective, many borrowers with surplus cash would want to prepay some of their loan. It would help reduce the tenure or EMI or both. Most banks and housing finance companies also encourage this, with some like HDFC allowing prepayment up to 25 per cent of the loan amount in a year without any penalty.
But choice between prepayment and investing is not easy.
Prepayment advantage: For someone, who took a home loan of Rs 50 lakh for 20 years at 10 per cent three years earlier, the initial EMI was Rs 48,251. Now, if the rate rises to 13 per cent, 300 basis points, in two tranches, his EMI would rise to Rs 58,180, with no rise in tenure.
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If he pays Rs 2 lakh as prepayment after 30 months, his interest savings after keeping the EMI the same is Rs 27,607. In terms of tenure, it will come down from 210 to 181 months.
Before taking the decision to prepay, though, the profile of the person becomes important.
Invested in equities: An aggressive person who will invest in equities should take the option. Returns on equities in the past three years have been low, but over a longer period, they have been exceptional. Large-cap funds have returned 7.67 per cent annualised for the past five years, 6.36 per cent in three years and minus 11.71 per cent in one year.
Around Rs 2 lakh invested in a large-cap fund, therefore, would have returned Rs 2.89 lakh in five years and Rs 2.5 lakh in three years. And, tax-free. So investment is a better option than prepayment.
Invested in gold: In case the person is not so aggressive and looks at gold as an investment avenue, the answer is a definite Yes. Gold exchange traded funds have returned 34.25 per cent annually in the past three years. About Rs 2 lakh invested in it would have returned a whopping Rs 4.84 lakh. In fact, physical gold has returned 19.47 per cent annually in the past decade. Even after taxation of 20 per cent, it's a good investment. In the case of ETFs, the taxation is as applicable to debt instruments.
"Equities and gold have given great returns over time. If one is investing in these instruments, prepayment can be postponed," says certified financial planner, Suresh Sadagopan.
Invested in gold: For the risk-averse investor, who is looking at parking the surplus in debt, it makes little sense to do so. Rather, prepay the loan. If one were to invest in a fixed deposit that is giving 10 per cent returns, post-taxation, the returns would fall to 6.5 per cent for a person in the highest income tax bracket. In numbers, it means returns of Rs 13,820 post-tax. The same would apply for other debt instruments. "In the present circumstances, investing makes sense only if the instrument is returning in excess of 13 per cent post-tax returns," adds Sadagopan.
An important thing that one needs to look at before deciding on prepayment is the balance loan tenure. Prepayment will make much more sense in the initial years because of the high incidence - almost 70 per cent - of interest cost. In the latter years, when the interest payment goes down, prepayment is not the best option.