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When you factor in the tax benefits, the returns from tax-free bonds are much higher compared to the effective cost of a home loan for investors in the higher tax brackets

 

 

The market is flooded with tax-free bonds. Besides the three existing offerings, the National Housing Bank is also expected to hit the market soon. These are compelling investment options because the tax-free interest rates offered are very high and comparable with the pre-tax rates on bank fixed deposits.

The decision may not be that easy for those with a home loan to pay. The common refrain is that if there is any surplus money, shouldn't it be used to prepay the loan? Most borrowers may opt to prepay their loans than invest in tax-free bonds. If you are faced with the same dilemma, consider these factors before you decide.

Look at prepayment as an investment

Much of the confusion gets cleared if you see debt prepayment as just another investment. If you prepay 1 lakh of a personal loan which was charging you an interest rate of 15%, you save 15,000 in interest per annum. And since money saved is money earned, your 1 lakh will effectively earn you 15,000 in a year. Evaluate your debts on the basis of the interest you are paying and start with repaying the costliest ones.
The credit card balance and personal loans should be the first in your cross-hairs. It doesn't make sense to keep money in a fixed deposit that fetches only 9% when you have a credit card outstanding with interest cost of around 42% and personal loans with interest cost of around 15%.

You may also encounter situations where the loans are cheaper than what your investments can earn. That's when you should stop prepaying the loan and start investing. Follow the simple rule that the return from the investments should be more than the interest on the loans.

A small caveat here: You must also consider the risks involved in the investments when you make the comparison. You should only consider relatively safe investments such as bank fixed deposits and bonds.

Take tax into consideration

The maximum returns offered by the tax-free bonds currently on offer is 8.92%, so the prepayment of loans continues to be a viable option if one goes with the above mentioned simple rule. However, the tax benefits on certain loans can change the equation in favour of investing. The effective cost of some loans comes down if the tax benefits on the interest is taken into account. Interest paid on education loan is deductable for 8 years from the starting date of repayment. For someone earning over 10 lakh a year, the cost of the education loan comes down from 13% to 8.98%. Similarly, the effective cost of a housing loan at 10.25% also comes down to 7.08% for the borrowers in the 30.9% tax bracket. The investor should not prepay the housing loan if he is in the highest tax bracket. Else, he can pay off the loan instead of investing. Here's another caveat: if the house is self-occupied, you can claim a maximum deduction of 1.5 lakh in a year. If your loan amount is very large and the annual interest far exceeds the 1.5 lakh limit, it may still make sense to prepay the home loan than invest in the bonds. There is no limit on the deduction of the interest if the house has been rented out.

Another point that needs consideration is the tax treatment of the returns from the investment. The post-tax return of a fixed deposit that offers 9% is only 6.22% for an investor in the 30.9% tax bracket. This is below the 7.08% effective cost of the housing loan. But the 8.92% coupon rate offered on tax-free bonds is significantly higher than the effective cost of the housing loan for investors in the 20.6% and 30.9% tax brackets. These investors should use surplus funds in this order: first invest in tax-free bonds, then prepay home loan and lastly invest in FDs.

 
Interest rates are expected to fall once the RBI is done with its measures to stabilise the rupee and control inflation. If rates fall, the taxfree bonds should fetch good returns in the medium to long term. However, don't think that this strategy is completely devoid of risks. Most housing loans are not fixed but at floating rates of interest. In the unlikely event of rates going up, the EMI will also rise. On the other hand, the value of the long-term tax-free bonds in the secondary bond market will come down.

Future requirements

The future cash flow requirement is another thing to consider when prepaying your home loan. It is always better to keep some extra money in hand for contingencies. If you prepay your housing loan to your maximum ability and need money in future for some unexpected event, you will be forced to go for personal loans.

To conclude, debts such as a home loan are should not be prepaid aggressively. Irrespective of whether or not you prepay your loan, the ultimate objective is to have a large pool of investments and no debt by the time you retire. All these debt versus investment discussions are only short-term decisions.

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