Indians have traditionally been credit averse. And, when it comes to a possession like a house that has an emotional attachment as well, the common thought process would be to prepay the loan as soon as possible. There is no doubt that outstanding debt does add to some amount of stress. Even if one has more than adequate income and can clearly see the income only improving in the future, the repayment of home loan gets considered. But is paying off the home loan a good idea? Not always. Since every one works towards creation of wealth, the thought of prepaying that home loan may actually be a deterrent in one achieving that financial objective.
Let us look at an example. Randeep Singh bought the house about 10 years ago. He had exhausted all his saving in covering up the down payment and doing some basic interiors of the house. Now he has had a windfall gain from the proceeds of an ancestral property getting sold. Owing to this amount been received, he is planning to pay off the existing home loan. Should he do it? Like Randeep, if you are also planning to prepay your home loan, consider the following before arriving at a conclusion.
Home Loan is the cheapest loan
Among all formats of credit available to you, this is the cheapest form of credit. The home loan interest rate will always continue to be the lowest in comparison to the other loans. Radeep also has one personal loan and a considerable outstanding on his credit cards. Ideally, he must pay off the high cost debt first but his thought process is to get rid of the high value loan first. Considering that the home loan rates today hover around 9% as against an average rate of 16% being charged on the personal loan, he must pay off the personal loan first. The outstanding on credit cards costs anything upwards of 40% if the credit is revolved. Thus it makes it a no brainer on paying off that credit card outstanding before any other credit outstanding.
Income tax benefits
The income tax concessions available on the home loan, further reduce the effective cost. This may come down by another percentile and the effective interest rate may be as low as 7.5%. When a large amount of money is available at such a low rate of interest will it be a good idea to close that loan out completely? Randeep must consider the tax benefits into calculation since it is a big advantage. Not only does the principal amount paid during the financial year will help him tax benefit under section 80C but even the interest amount paid in the same financial year will help him reduce his income by 2 lakh and thus further reducing the taxable income.
MF may give higher returns
As against an effective interest of 7.5%, if Randeep deploys funds in mutual funds, he may be able to get a higher return. Even the debt funds have been on an average giving a higher return than 7.5%. Randeep should rather invest the funds. The investment will help him earn a higher rate of interest and thus create wealth. He would always have the security of paying off the loan if a need arises.
Term of loan served
A larger part of EMI on a HL gets apportioned towards the interest in the initial years. As the term increases, so does the principal amount getting repaid from each EMI. So if the loan has already been served for a longer period then the actual interest being served will come down. In Radeep’s case since the loan has already been served for about 10 years, he can easily chose to continue with it since majority of interest has already been paid.
Helps in building credit profile
Vintage of a credit facility helps in building credit profile and would further facilitate better terms on other loans that one may need. If one continues to pay in time without having his name getting updated in loan defaulter list, he would be able to access loans at cheaper rate of interest. Thus making the whole proposition highly lucrative.
So if you are planning to fore close that home loan, consider the above factors before arriving at a decision. It may not always be a good idea to close it.