April is the month for employees to receive their annual bonus for the previous financial year. If the appraisals go well, one can expect to receive lucrative bonuses and pay hikes. There is happiness after more money in hand; But confusion also arises in the mind. What to do with this money? Such a question arises.
If you get extra income due to bonus, salary increment or any other reason, then confusion can arise in your mind. Will it be beneficial to pay off home loan early? Should this money be invested in equity mutual funds? Should you buy gold? Such questions arise.
Assess profit and loss
Before deciding to choose between pre-paying a home loan and investing in mutual funds, one should consider the pros and cons of both the options. For this, one should compare the interest rate of home loan and the potential annual return of mutual fund and also know the tax difference in both the situations. Moreover, financial goals, risk tolerance and liquidity position should also be considered. It will be right to take a decision only after considering all these things. These aspects should be carefully considered.
Effect on liquidity
Capital liquidity should be assessed before deciding to pay off the home loan early. That is, how much additional revenue will be needed, and will it be needed in the future? This should also be checked. If you deposit the bonus money in the home loan, it will not be returned. At the same time, investments accumulated in equity mutual funds can also be withdrawn if required.
Ability to take risks
There is no risk in paying off the home loan early. That amount is directly credited to the home loan and reduces the loan amount. If you are paying 8.5 percent annual interest on a home loan and paying a lump sum to pay it off early, the 8.5 percent return is guaranteed. At the same time it assumes an expected return of 12 percent on equity mutual funds. However, it is not guaranteed. So before investing in mutual funds one should assess the risk tolerance.
Investment Objectives
Whether pre-payment of home loan is better for you or investing in mutual funds depends on the investment objective. If you are planning to invest regularly for a long time to build up a fund for retirement or children's education, mutual funds can be a good option for you. However, if your retirement is not too old and you are not in a position to invest regularly for good returns, paying off your home loan early can be beneficial.
Comprehension of taxes
While opting for one of the two options, one has to look at how the taxation may be or how much impact it may have. Because payment of interest on home loan gives an additional tax deduction of up to two lakhs per annum under Section 24B. Apart from this, if the principal is paid, tax deduction is also available as per Section 80C. Actually, as per Section 80C, the benefit of tax deduction on investments up to Rs.1.5 Lakh per annum is also available in Equity Mutual Funds. However, as per section 24B, additional tax deduction of up to two lakhs can be availed only on home loan interest. If you pay off your home loan early, you will not get the benefit later. Of course, if invested in equity mutual funds for three years, no tax is levied on profits up to one lakh per annum. However, if the profit is more than that, the Long Term Capital Gains (LTCG) tax has to be paid at the rate of only 10%. In a sense this is a good option from the point of view of tax savings.
Remember this
Before deciding whether to use surplus funds or salary, one should look at the interest rate of the home loan and how much return is expected from investing in mutual funds. If the home loan interest rate is between 8.5 to 9.5 percent and assuming a return of twelve percent per annum from equity mutual funds, then investing in mutual funds can obviously be profitable as the returns from investing in equity funds are two and a half percent more than the home loan interest rate. At the same time, investing in equity funds for a long period of time will yield higher returns than the home loan interest rate. Investing in Equity Mutual Funds through SIP provides the benefit of compounding and averaging. That is, from the point of view of return and growth alone, investing in equity mutual funds can be a good option.
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