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The factors to consider before deciding to repay your loan early

LiveMint logoLiveMint 12-07-2017 Lisa Pallavi Barbora

If you are continuing to pay equated monthly instalments (EMIs) on a home loan and wondering if it makes sense to repay the principal rather than continuing it, keep in mind these three checks before making a choice.

As a thumb rule, continuing a loan makes sense if your interest rate is lower than the potential return on investment for the lump sum. Let’s say, you have Rs10 lakh left to repay. If you use this for repayment, you save on an annual interest cost of say 8.5%. Now, if you don’t repay the loan, you can invest the Rs10 lakh in other securities. If there is an investment opportunity where you can earn more than 8.5% per annum, assume 10%—it will make more sense to utilize the corpus towards the investment rather than repayment. By doing so, your net result is a gain; in this case, it’s an annualized gain of 1.5%. You earn 10% on the corpus and utilize 8.5% out of that for the EMI; rest is yours. By repaying the loan in full, you miss the opportunity for higher returns.

If the loan has less than 5 years to finish, chances are that you are repaying more principal with each instalment rather than interest. Interest proportion in an equated monthly payment is on reducing balance. The question of early repayment is more relevant when your interest component is high. Also, it could be that the alternative investment you want to make with the lump sum is in equity or a combination of equity and debt to earn more than the interest you pay. However, equity-linked returns are usually not linear, which means you are likely to see desired annualized return only if you remain invested for at least 5-7 years. Hence, don’t substitute such an investment instead of the repayment if time to repayment is only a few years.

A housing loan gives you a tax benefit on the principal repayment and on the interest repayment (if you have the possession). To that extent, if you are claiming tax benefit, your net annual cost of the loan is lower. Make this calculation and then assess if you will be able to earn more per annum by investing the lump sum; if not then it makes sense to repay.

Other than these above considerations, consider pre-payment fee or cost if any.

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