Case 064Lending and leverageCore

A client has an Rs 80 lakh home loan at 8.75% with 15 years left and a Rs 30 lakh bonus. Should he prepay or invest? Compare the certain saving with the uncertain return.

The situation

Abhijit Datar, 41, has Rs 80 lakh outstanding on his home loan at a floating 8.75%, with 15 years left and an EMI of about Rs 79,956. He has received a Rs 30 lakh bonus and already holds a six-month emergency fund.

He can prepay the loan without penalty, keeping the EMI unchanged so the tenure shortens, or invest the Rs 30 lakh in an equity-heavy portfolio for 15 years. For this case, take equity gains as taxed at an illustrative 12.5% when sold. Whether the home-loan interest gives him any tax deduction depends on the tax regime he uses and the caps in force; treat that as a framework to confirm.

Your task

What does prepaying save, what return must investing beat, and what would you advise?

Quick check

Prepaying Rs 30 lakh is financially equivalent to what?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Prepaying earns a certain 8.75%: it saves about Rs 46.9 lakh of interest and cuts 96 months off the loan. To beat that, the investment must earn about 9.5% a year before tax for 15 years, with the risk of falling short. With an emergency fund in place and no cheaper debt to clear, prepaying most of the bonus is the sound default; investing wins only if he accepts the risk for an expected extra few points.

Step 1What does prepaying actually earn?

Paying off a credit card charging 36% is the best investment most people will ever make, because every rupee repaid stops being charged 36%. Prepaying a loan earns exactly its interest rate, 8.75% here, with no risk and, if the interest brings him no deduction, no tax. Keeping the EMI at Rs 79,956, the loan now ends after 84 months instead of 180, and total interest falls from Rs 63.9 lakh to Rs 17.0 lakh, a saving of Rs 46.9 lakh.

Rs lakhNo prepaymentPrepay Rs 30 lakh
Loan outstanding80.050.0
Monthly EMI, Rs79,95679,956
Months to repay18084
Total interest still to pay63.917.0
Interest saved46.9
With the EMI unchanged, prepaying Rs 30 lakh shortens the loan from 180 to 84 months and cuts the interest still to be paid by Rs 46.9 lakh.
Step 2What must the investment earn to beat that?

Put both routes on the same 15-year footing. Prepaying is like investing Rs 30 lakh at a certain 8.75%, which grows to Rs 105.6 lakh. After an illustrative 12.5% tax on gains, the investment must earn about 9.5% a year before tax just to tie. At 12% it ends at Rs 147.4 lakh, ahead by Rs 41.9 lakh; at 6% it ends at Rs 66.7 lakh, behind by Rs 38.9 lakh. The expected margin over 15 years is a few points a year, bought with real uncertainty.

Rs 30 lakh after 15 years: prepaying earns 8.75% for certain (Rs lakh)Prepay: certain 8.75%105.6Invest at 6% a year, after tax66.7Invest at 9% a year, after tax99.4Invest at 12% a year, after tax147.4Break-even: investing must earn about 9.5% a year before tax to match prepaying,with the risk of falling short, while prepaying's result is known today.
Over 15 years, prepaying is worth a certain Rs 105.6 lakh, while investing gives Rs 66.7 lakh at 6%, Rs 99.4 lakh at 9% and Rs 147.4 lakh at 12% after an illustrative 12.5% tax, so it needs about 9.5% a year before tax to tie.
Step 3How does the tax deduction change the answer?

Only at the margin. If interest on the loan is deductible and he is below the annual cap, the loan's effective cost is lower than 8.75% and investing becomes more attractive; if he pays interest well above the cap, or uses a regime without the deduction, the rupee of interest saved was never deductible and prepaying still earns the full 8.75%. On Rs 80 lakh his first-year interest is about Rs 7.0 lakh, so check which case he is in before deciding, against current rules.

Close with a view he can act on. With an emergency fund in hand and no costlier debt, prepaying most of the bonus is the sound default, and a split, say Rs 20 lakh prepaid and Rs 10 lakh invested, is reasonable if he wants some equity exposure. The limit: once money goes into the loan it is hard to get back, so he should keep enough liquid to cover job loss or a medical event before prepaying anything.

Where candidates lose it

The common error is comparing 8.75% with an expected equity return of 12% and declaring investing the winner. That compares a certain return with an uncertain one, and before tax with after tax.

The second miss is ignoring liquidity. Prepaid money is locked into the house; a candidate who says prepay everything without checking the emergency fund has missed the client.

What the interviewer asks next

  • The loan rate falls to 7.5%. Does your answer change?
  • He expects a promotion and a larger bonus next year. How does that affect the split?
  • Should he reduce the EMI or the tenure when he prepays?

Company names and figures are illustrative.