Should you invest or pay off your home loan?

Today's discussion is about whether a person with surplus money should choose to pay off his home loan or invest it. But before that, I want you to tell us something about the changes in the interest rate structure of home loans that has recently come about.

Dhirendra: It is about bringing some degree of accountability to banks. Right now what happens is, every consumer hears the story that interest rates are coming down. The rates on our deposits are coming down. And the expectation is that if you have borrowed money, then even the interest on that should come down. But it rarely happens.

So RBI has come up with a framework that when interest rates come down, banks should automatically reduce the interest rate on home loans. It should not be dependent on the request, mercy, or the choice of the bank.

RBI has come up with a rule that effective October 1, new home loans shall be externally benchmarked. The banks have a choice either to choose the repo rate, the three-month or the six-month treasury bill rate. So they can choose one of these as the base and beyond that they can charge a mark-up or a spread. So if repo rate comes down, the interest rate on your home loan will automatically come down. It will not be dependent on the mercy of the bank.

A part of the spread would also differ from person to person. There are different people with different credit worthiness. Somebody will be more credible depending on his income and track record while another would be less credible. So banks also charge a risk premium depending on this and a lot of other factors. So here is the catch. This spread is still in the hands of the bank and will impact your effective borrowing rate. So don't expect dramatic changes. There will be a difference, but it is not likely to be a huge one. And the interest rate may also go up substantially when the repo rate increases. So it's a two-way street.

I would now go back to the main topic of our discussion, that is, if I have a surplus amount of money, should I invest it to create more wealth or should I pay off my home loan?

Dhirendra: I would say invest that money methodically, the reason being that this is the only loan that is acceptable for an individual to have. This borrowing is not for consumption. It is for an asset which will save you the rental outflow if you are living in a rented house. So in that sense, it is accumulating.

Also, the long-term interest rate on home loans is such that I feel that the long-term return on investment will be higher than the home loan cost. The interest rate on home loans is quite low. And for many people it also saves on taxes.

So if there is going to be a cost of somewhere around 8.5% on a home loan, and if you're going to generate more returns on that money over a 15- or 20-year time frame, why not go for that additional return and benefit from it. Home loans are usually for a period of 15, 20 or 25 years. And I am confident that equity investment will generate much higher returns over such a long period. So the choice is clear.

Are there any exceptions to this advice? Would there be any people who should anyway use the surplus to pay off their home loan?

Dhirendra: Yes. I would say if you are getting very anxious about your job, your career, the loan and the future cash flows, then you may choose to pay off the loan. Suppose you are in an industry which is not very stable or your job is not of a very stable nature, then you may want to pay off the loan. Carrying the home loan would require a certain periodic payment in the form of EMIs. And if that is making you anxious because of the unsurety of cash flows, pay off the loan first. That would help you get a nice sleep.

Also, many times what happens is that you get emotional while making the home buying decision. You take a big house or a house of your choice, which may not fit into your budget. And have now somehow been able to accumulate something, then prepaying a part of it can bring some level of comfort to you. Say, if the loan EMI sweeps away 50-60 per cent of your income every month, you would have no other option but to prepay a part of it so that the EMI can come down, giving you some level of comfort.

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