by Living life debt free is often considered as a Supreme Goal of Financial Planning. However, to achieve this Goal one has to make efficient financial planning, as well as full-heartedly, follow it. If we talk about a Home loan, the tenure stretches to 20 years to 30 years which covers your whole working life (i.e. from the job starting age of 25 years to retirement age of 60 years). However, owning a house is a dream of every Indian and thus the debt starts with the start of a job.
Now here comes the question that whether one should go with reducing the debt (home loan prepayment) or do the SIP investment from the additional monthly surplus. This question is majorly faced by the salaried class who have some investible surplus at the end of the month. Few aspects one needs to keep in mind while deciding what to do with the available investible surplus are:
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Home Loan Prepayment vs SIP
Investment Returns vs. Interest Payment
In the current market scenario, the home loan interest is in range of 8% p.a. to 9% p.a. on the reducing balance method i.e. on the principal amount outstanding at the month end. Since the interest rates are based on MCLR (Marginal Cost of Funds Based Lending Rate), interest rates there may be slight variations however largely the rates remain fixed.
On the other hand, the returns from the mutual funds are volatile, however, if we see the returns for a longer perspective say 15-20 years than one can safely assume to fetch a return in the range of 12% to 15% annualized returns.
As of April 2019, there is around 307 open-ended equity (close-ended funds are not considered because you cannot invest money in them), out of which 219 schemes have been around from the last 10 years or more. Out of these 219 funds, more than 100 funds have delivered returns for more than 12% annualized for 10 years. So there are good probabilities of earning returns exceeding 12% annually through mutual funds.
Tax Effects
There is a deduction under section 80C for the home loan repayment (principal part) and interest paid on the home loan is also deductible up to ₹ 2 lakhs under section 24(B). The tax deduction under both sections cumulatively provides a maximum of 1 % savings in the interest rate. The net interest rate post-tax-savings can be assumed at 7.00% to 8.00% per annum.
At the same time, Tax on the short-term gains i.e. redemption before 1 year is taxed at 15% while 10% on the gains for the redemption done after completing 1 year. So the post-tax return comes in the range of 10.5% to 13.5%.
So we can clearly see that you could only save 8% if pay goes for Home Loan Prepayment but if you invest in through SIP you would earn around 3% to 4% extra.
Practical Approach for SIP or Home Loan Prepayment?
Suppose you have got a home loan of ₹ 50 lakhs for 30 years (i.e. 360 monthly installments) at the interest rate of 8.70% p.a. The EMI comes to ₹ 39,157 and the total interest outgo in the loan tenure will be ₹ 90.96 lakhs. The next year you decided to reduce the debt with a monthly increment of ₹ 15,000. The loan which was going to get over in 2049 with the regular EMI of ₹ 39,157 will get over by 2032 i.e. around 17 years reduction (i.e. 206 monthly installments) in the repayment period and the total saving in the interest outgo will be ₹ 58.29 lakhs.
Now if the increment of ₹ 15,000 is put into SIP for 17 years (i.e. 206 months which is equal to the time in which the home loan is fully paid with the increment of ₹ 15,000), assuming the normal rate of return of 12% p.a., the returns would be ₹ 87.82 lakhs.
After 17 years, you will be having the amount of ₹ 87.82 lakhs with which you can pay the home loan amount outstanding of ₹ 36.51 lakhs at the end of the 17th year and still left with a surplus of ₹ 51.31 lakhs in hand.
There is another practical approach where the comparison is made on the time basis i.e. if you want to buy a house now valuing ₹ 70 lakhs with EMI of ₹ 54,819 for a tenure of 30 years. Put the same EMI i.e. ₹ 54,819 in SIP for 10 years assuming a rate of returns of 12% compounded annually and you would get around ₹ 1.25 crores and at an inflation rate of 10%, the house which cost ₹ 70 lakhs previously would cost ₹ 1.25 crore after 10 years.
So the same house which you would have own in 30 years i.e. after home loan prepayment would be yours within 10 years that too with no debt and you can continue the EMI amount in SIP for next 20 years which would result in an enormous amount of ₹ 5 crores.
The above figures show that Mutual Funds is the clear winner and it can also be said that in the long term no other asset class can provide the returns similar to mutual funds.
