Summary of this article
Prepaying a home loan offers assured interest savings at 8.5 per cent
Equity mutual funds may deliver higher returns over longer investment periods
Experts suggest balancing loan repayment, market risk and emergency savings
Your Diwali bonus may soon land in your bank account, tempting you to spend it on festive shopping, travel or a long-pending purchase. But before the money gets used up, it is worth deciding whether it would be better spent reducing your home loan or invested in mutual funds to build wealth over time.
For borrowers paying 8.5 per cent interest on a home loan, both options have their merits. Prepayment reduces the interest payable to the lender and offers a relatively certain benefit. Equity mutual funds, on the other hand, can generate higher returns over the long term, but come with market risks.
Aditya Agarwal, co-founder of Wealthy.in, a wealth management platform for mutual fund distributors, says prepaying a home loan at 8.5 per cent is comparable to earning a guaranteed return at that rate. "Prepaying a home loan at 8.5 per cent is like earning a guaranteed 8.5 per cent a year, with no market risk. Equity funds can potentially earn more over long periods, but without any guarantee," he says.
Rs 1 Lakh Diwali Bonus: Home Loan Prepayment Vs Mutual Funds
Consider a borrower with Rs 1 lakh to spare. If the money is invested in an equity mutual fund at an assumed annualised return of 10 per cent, it could grow to around Rs 1.61 lakh in five years, Rs 2.55 lakh in 10 years and Rs 3.93 lakh in 15 years after factoring in long-term capital gains tax and health and education cess of 4 per cent.
At an assumed return of 12 per cent, the values could rise to Rs 1.76 lakh, Rs 3 lakh and Rs 5.07 lakh, respectively.
The calculations assume annual returns of 10-12 per cent and a 12.5 per cent LTCG tax on gains exceeding Rs 1.25 lakh, with the tax exemption available to the investor. These are illustrative figures, not assured returns. Actual mutual fund returns will depend on market performance and may be lower or even negative, particularly over shorter periods.
By comparison, using the Rs 1 lakh to prepay a home loan carrying 8.5 per cent interest would offer an equivalent compounded benefit of around Rs 1.50 lakh over five years, Rs 2.26 lakh over 10 years and Rs 3.40 lakh over 15 years, according to Aggarwal’s calculations. This is a simplified way of showing the equivalent compounded benefit of avoiding an 8.5 per cent borrowing cost. It is not an exact calculation of interest saved on an amortising home loan.
Agarwal says the difference between the two options becomes clearer over longer periods, but investors should also keep the risks in mind. "Over 15 years, Rs 1 lakh in an equity fund could grow to roughly Rs 3.9-5.1 lakh after tax at assumed returns of 10-12 per cent a year, against an effective Rs 3.4 lakh from prepaying. Over five years, though, the difference is small, and a single bad year can wipe it out," he says.
Borrowers with shorter investment horizons or lower risk appetite may prefer prepayment, while those who can stay invested for 10-15 years may consider equity funds. Splitting the bonus between the two is also an option. "It need not be all-or-nothing; splitting the bonus between the two is often the most practical answer," Agarwal says.
How Much Interest Can A Rs 1 Lakh Prepayment Save
The savings depend on the outstanding loan amount, remaining tenure and interest rate. To explain this, Agarwal gives the example of a borrower with Rs 40 lakh outstanding, 20 years left on the loan and an interest rate of 8.5 per cent. The monthly EMI in this case would be around Rs 34,713, with total interest payable of approximately Rs 43.31 lakh over the remaining tenure, assuming the rate remains unchanged.
According to Agarwal's calculations, prepaying Rs 1 lakh while continuing with the same EMI could reduce the loan tenure by around 14 months and save approximately Rs 4.18 lakh in interest. If the borrower instead opts to reduce the EMI while retaining the original tenure, the monthly payment would fall by around Rs 868, but the interest savings would be limited to about Rs 1.08 lakh.
Keeping the EMI unchanged and reducing the tenure therefore offers greater interest savings, provided the borrower can afford the existing monthly payment. Agarwal recommends making prepayments early in the loan and choosing a shorter tenure rather than a lower EMI. "Prepaying early in the loan, and asking for a shorter tenure rather than a lower EMI, gets the most out of every rupee," he says.
What Return Must Mutual Funds Generate To Beat Prepayment
Agarwal says borrowers should compare the post-tax returns from equity mutual funds with the interest saved through home loan prepayment. Based on the calculations, an equity fund would need to deliver an annualised pre-tax return of around 8.5-8.8 per cent over five to 15 years to match the benefit of prepayment, assuming the investor can use the Rs 1.25 lakh LTCG exemption. If the exemption has already been used elsewhere, the required return could be around 9.2-9.5 per cent.
However, Agarwal cautions that investors should not choose equity funds just because their expected returns match the home loan rate. "Prepayment is guaranteed; equity returns aren't, and can be negative over a few years. Borrowers should expect equity to beat the loan rate by a clear margin before choosing it," he says.
Tax treatment of home loan interest also matters. Under the new tax regime, borrowers cannot claim a deduction on interest paid on a self-occupied property. Under the old regime, eligible borrowers can claim a deduction of up to Rs 2 lakh a year, subject to applicable conditions. This can lower the effective borrowing cost, although the benefit depends on the interest paid and the borrower's tax position.
Should Floating-Rate Borrowers Prioritise Prepayment
Borrowers with floating-rate home loans should also track of changes in interest rates. The Reserve Bank of India (RBI) raised the repo rate by 25 basis points to 5.50 per cent on October 7. If banks pass on the increase at the next reset, borrowers could face higher interest costs, making prepayment more attractive. However, the timing of rate resets varies from one lender to another.
"If lending rates rise, the cost of carrying the loan increases, strengthening the case for prepayment. Conversely, falling interest rates reduce the effective cost of borrowing and may make equity investment relatively more attractive," explains Professor Jayatu Sen Chaudhury, finance and accounting professor at International Management Institute (IMI), Delhi.
When rates rise, lenders generally extend the loan tenure instead of increasing the EMI. This can keep monthly payments unchanged but leave borrowers paying interest for longer. A part-prepayment can help reduce the outstanding principal and limit the additional interest burden. Individual borrowers with floating-rate home loans are also protected from foreclosure and prepayment penalties under RBI rules.
Final Verdict: What Should Borrowers Do
For a borrower paying 8.5 per cent interest on a home loan, Professor Chaudhury favours using the Rs 1 lakh bonus for prepayment, provided the borrower has adequate emergency savings and no higher-cost debt to repay.
Agarwal advises borrowers to keep their financial priorities in order before using the bonus to repay debt or invest. "No one can predict rates, so do not try to time it. Keep an emergency fund in place first, then decide how to split the bonus based on your horizon and comfort with risk," he says.
Using the entire Diwali bonus to prepay a home loan may reduce interest costs, but it also locks away money that could be needed during an emergency. Investing the full amount in equities carries market risk. Borrowers should first set aside adequate emergency savings and then decide how much of the bonus they can comfortably use for prepayment or long-term investments.
The choice, Professor Chaudhury says, comes down to balancing two financial priorities. "Ultimately, the decision is not simply about maximising returns. It is about balancing potential wealth creation against the certainty of reducing financial obligations," he says.
