Pre-paying Home Loan Vs Investing in Equity Mutual Funds

If you got some surplus money, is it better to pre-pay home loan or is it better to invest the money in equity mutual funds? Let’s find out.

Average CAGR of different categories of mutual funds:

Scheme category	Last 5 years Avg CAGR	Last 10 years Avg CAGR
Multi-cap schemes	22.9%	17%
Midcap schemes	26%	19%
Smallcap schemes	29.5%	20%
Contra schemes	24%	17.5%

 CAGR – Compounded Annual Growth Rate

I will assume 17% as Equity mutual funds CAGR return for the calculations in this write-up.

Average home loan rate has been around 8.5% p.a. And it might fall in the coming years if RBI reduces policy rates, once inflation is contained below their target rate. I will take 8.5% as home loan interest rate for the calculation.

Let’s assume that one Mr Kiran has an outstanding home loan of 40 lakh.

Balance loan duration: 20 yrs

Interest rate: 8.5% p.a.

EMI: 34,712

Mr Kiran has a surplus of 10 lakh that he received from some source. Should he use this money to pre-pay the home loan or invest it in equity mutual funds? Let’s check both the scenarios.

Scenario-1: 

1.   Mr Kiran will use surplus of 10 lakh to prepay the loan, and his outstanding loan comes down to 30 lakh.

2.   And he keeps paying the EMI over the next 10 yrs (120 months). After 10 years, outstanding loan will come down to ₹ 4,67,105. This amount is his liability after 10 years.

Scenario-2:

1.   Instead of pre-paying home loan, Mr Kiran will invest the surplus 10 lakh in Equity mutual funds. After 10 years, the mutual fund investment will grow to ₹48,06,828 (@ 17% CAGR). This amount is his asset.

2.   After 10 years, outstanding loan amount would have gone down to ₹ 27,99,752, which is his liability.

3.   After 10 years, Mr Kiran has created an asset of ₹ 48,06,828 and has a liability of ₹ 27,99,752.

4.   So his net asset i.e., asset – liability is ₹ 20,07,075.

Scenario-1: Liability of ₹ 4,67,105

Scenario-2: Net asset of ₹ 20,07,075

There is a difference of ₹ 24,74,180 (20,07,075+4,67,105) between the two scenarios.

Just imagine the impact if the surplus amount is 20 lakh and/or if the duration for calculation is increased to 20 yrs. It will be huge!!!

Conclusion:

Home loan is the cheapest loan available. It’s better to continue the loan instead of pre-paying it, and invest the surplus in equity mutual funds for long-term (8 years or longer).

Disclaimer:

Mutual fund investments are subject to market risks. Please read the scheme information and other related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements before choosing a fund, or designing a portfolio that suits your needs.