Friday, 15 April 2016

Should you use surplus funds to pay off your home loan?

Mira and her husband Navin were celebrating at home; as Mira’s bonus from work had just come in post the annual appraisal. With surplus funds in hand, they were debating how to utilise the funds. Mira was all for spending a chunk of it to take the family on a much-deserved vacation, and saving the balance. On the other hand, Navin was of the opinion that they should use all of the money to clear off their existing home loan. What do you think would be the best approach? Would it make better financial sense to invest the funds, or pay off the loan instead?
The decision of whether to pay off an existing home loan or to invest the surplus funds elsewhere, be it mutual funds, fixed deposits or any other form of investment is always a tough call. However, there are pros and cons to both the choices and before you do decide on which one to make, it’s best to weight in your options. This will help you make an informed choice.
Remember that when you avail of a home loan, the average cost of your home goes up, because you need to factor in the interest rate in addition to the principal repayment, and home loans do not come cheap. Hence if by paying off a loan each month you are likely to be eating into your money, it makes good sense to prepay the loan with the surplus funds in hand. This will also reduce your debt burden to a large extent, possibly freeing up the money you were paying by way of an EMI to another investment avenue. Also, this will pave the way for the chances of your buying another property that much sooner, ultimately resulting in better profits.

Further, consider the stage of the home loan you are at. If you are in the early stages of your home loan, paying it off with surplus funds is probably a good idea, since you have not serviced the loan much. Typically a home loan is for a 20-year tenure and the closer you get to the end of the tenure, you have already paid a significant amount by way of interest. Hence pre-closing the loan at this stage may not make much sense. Also factor in the loan processing fee you would have paid, when calculating the cost of your loan and keep in mind the home loan rates.

When you choose to repay a home loan, you typically have two options – (a) reduce the tenure, or (b) keep the tenure constant by reduce the EMI. With most lenders the default option is to reduce the tenure, but you can always choose to work on the EMI instead. However, the edge that reducing the tenure gives you is a proportional reduction in interest cost as well. Not doing so may defeat the purpose of loan prepayment. Another option that you can avail of is to increase the EMI, and deploy your surplus funds in that manner, bringing down the overall loan tenure.

What makes a home loan attractive for most homeowners is the tax benefit available under Sections 24(b) and 80EE of the Income Tax Act, 1961, which is why people tend to debate about whether to pre-close a home loan or not. However, even this comes with a downside – if the interest cost adds up to more than what you save by way of a tax deduction, probably closing the loan would be more prudent.

What next, then?
Well, if you choose not to pre close your home loan, consider alternative investment options with your surplus funds. Keep in mind that you should ideally choose an option that does not result in paying a heavy amount of tax, else the purpose of investment is somewhat diluted and you would likely have been better off clearing off your home loan instead. Select an option that gives you tax benefit and makes your money work for you.

In conclusion
Remember that whether you prepay your home loan or choose to continue with it for the complete tenure, your credit history will reflect your repayment behaviour. Hence in order to increase CIBIL score, do ensure that you make timely payments towards your home loan EMI. 

Finally, when it comes to paying off the loan, also keep in mind that you would not want to fall back on your other commitments, be it monthly household expenses, other EMIs or as in the example at the beginning of this piece, use some of the funds to go on holiday. Whatever be your decision, make your decision after considering your personal situation in addition to factoring in the pros and cons of doing so. 

A CIBIL report can be the backbone of your financial fitness and hence it becomes imperative to take adequate precaution to ensure it does not slide. After all, a good score can help you when you need a fresh line of credit the most.

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