Preclosure of a home loan is the early repayment of a home loan by the borrower. It can be performed either in part or in full. It is performed to avail reduced rates by means of balance transfer or optional refinancing. It is also possible when a home loan borrower of either bank or NBFC like LIC Housing Finance secures adequate funds and try and make complete repayment earlier than mentioned in the home loan agreement.
Traditional wisdom suggests it is better to prepay any kind of debt, as it not only saves interest cost and reduces the loan repayment tenure but also caters to financial freedom. However, financial theory recommends if your investment returns after tax are greater than your after-tax cost of debt, then you must invest. Alongside, other factors like the creation of retirement corpus, maintenance of emergency fund, job security, risk profile, liquidity position must also be considered before making a choice.
Therefore, the answer to this question is not simple. Multiple factor analysis is a must before making the final decision. Listed below are key pointers you must consider when you get confused between prepayment of your home loan of LIC Housing Finance or any other lender and investment.
While RBI has disallowed lenders from charging any prepayment fees on the floating interest rate home loans of banks or NBFCs like LIC Housing Finance, lenders offering home loans at fixed interest rate home loans are free to charge prepayment fees on prepayment. Therefore, prepayment of a loan is profitable when the interest component of the loan exceeds the prepayment charges.
Strike comparison with savings generated through loan transfer option
While prepayment of home loans like LIC Housing Finance can lower your interest cost, choosing this opting by redeeming your investments can impact your financial health in a negative manner. In case you select the option of a home loan balance transfer, your existing home loan gets taken by another home loan lender at a reduced interest rate. Doing so would reduce your interest payout without affecting your existing liquidity and investments.
Optimise interest outgo after-tax deduction
Prepaying high-cost loans like personal loans, car loans, etc., are a better option than opting for investment. This is because the investment returns after tax might be lesser in comparison to the loan interest. The interest rate for personal loan range between 10 % and 24 % p.a, rate of interest for a car loan can go up to 16 % p.a. Additionally, personal loan, car loan, durable consumer loan offers no tax benefit.
However, you require thinking over low-cost loans like a home loan. The interest rate for a home loan offered by banks and NBFCs like LIC Housing Finance begins from 6.75 % p.a onwards. Also, under section 24B, the Income Tax Act allows a deduction of Rs.2 lakh on the interest paid during the financial year for a home loan. On considering tax benefits, the effective interest rate on home loans decreases. For instance, for a home loan worth Rs.23 lakh for a tenure of 20 years with a rate of interest of 9 %, the interest cost for the first year will be Rs.2.05 lakh. The deduction of Rs.2 lakh will result in a tax saving of Rs. 60,000 for a person in the highest tax bracket of 30%, Rs. 40,000 for a person in the 20% tax bracket, Rs. 10,000 for a person falling in the 5% tax bracket.
However, Rs.2 lakh is the maximum deduction which you can avail. If you have a home loan of a larger amount, then your interest amount for each year will be higher in comparison to what you can use for tax savings. For instance, if your home loan is worth Rs.45 lakh for a tenure of 20 years with an interest rate of 8.65%, then your interest cost for the first year will be around 3.85 lakh. Note that you can calculate your interest cost through the LIC home loan EMI calculator. In such a situation, prepayment would make sense for you to bring down your home loan outstanding to a margin at which you can avail of maximum tax benefit and consequently lower the effective cost of a home loan. Generally, if your loan is in the range of Rs.25-30 lakh, the interest amount will remain in the close range of Rs.2 lakh, at least for half the tenure. This enables you to avail of maximum tax benefits.
Build and maintain an emergency fund
Ideally, the size of an emergency fund must be at least 6 times your mandatory monthly expense to take care of contingencies like medical emergencies, job loss, et cetera. Though part prepaying the home loan of your bank of NBFC like LIC Housing Finance will lower your interest burden, but if you do not have sufficient emergency funds, you may end up taking an expensive loan during a financial emergency to meet monetary shortfalls. Therefore, you must prepay only the surplus over and above the emergency fund.
High return investment
If you are investing in schemes that yield higher returns than the cost of your loan, then investment makes sense than prepayment of your home loan from LIC Housing Finance or other lenders. However, if you are looking to invest in products yielding fixed income, then this option may not be rewarding for you. Investment in fixed deposits(FD) and recurring deposits (RD) does not make sense as such products fetch you a return of up to 4 to 6% p.a (post-tax, the return will dip further basis of the tax slab) which is lower than the loan’s interest rate.
However, equities have the capability to yield double-digit returns over the long term. For instance, if you earn an average return of 12% pa on your portfolio by investing in the asset class and you pay 9% post-tax effect loan debt, then investing is a good option as you are earning 3% every year. But if your current investments or opportunity cost gets you a lower return (post-tax effect) than the prevailing interest burden, then you must consider prepaying your loan.
The final decision to prepay or invest depends upon your situation and risk appetite; however, knowing all options and their implications assist you in making an informed decision.