This article is based on a query we received on whether or not it is advisable to pay more than the EMI amount back every month on the home loan, so as to reduce the tenure of the loan and become free from debt faster. Let’s see how the case pans out.
Let’s call this person who wrote to us Mr. A.
Mr. A has taken a home loan of Rs. 10 lakhs from bank at the rate of 10.50% p.a. for 20 years on monthly reducing balance basis. His EMI is Rs. 9,984 but because he has surplus of Rs. 5,016 per month he can increase his EMI to Rs. 15,000. Now he has 2 options, either he can increase the EMI or invest surplus amount in combination of Equity Mutual Funds and Debt Mutual Funds on which he can get approx. 10% p.a.
Which option should he choose?
In order to decide whether to increase EMI or invest surplus amount, we have to do some number crunching…
Option 1 - Increasing EMI
If Mr. A decides to increase his EMI from Rs. 9,984 to Rs. 15,000, he will be able to pay off his loan in 101 months i.e. 8.42 years instead of 20 years.
In the remaining tenure i.e. 139 months amount of Rs. 15,000 can be invested at 10% p.a., it will give him Rs. 38,22,945.
Option 2 - Investing Surplus
If Mr. A decides to invest surplus of Rs. 5,016 p.m for 20 years at the rate of 10% p.a. he will get Rs. 36,31,517.
Note: We have not assumed any tax savings on interest paid for home loans.
Comparison:
| Option | EMI | Loan Completed in period (Months) | Investment | Investment Rate | Tenure of Investment | Future Value of Investment |
|---|---|---|---|---|---|---|
| 1 | 15,000 | 101 | 15,000 | 10.00% | 139 | 3,822,945 |
| 2 | 9,984 | 240 | 5,016 | 10.00% | 240 | 3,631,517 |
| Excess value of investment by increasing EMI | 191,428 | |||||
- If we compare both the options we can analyse that in the 1st option loan is prepaid in just 101 months while it will take 240 months to pay off the loan if he doesn’t increase his EMI.
- Since the loan is paid in just 101 months in option 1, Rs. 15,000 can be invested for the remaining tenure of 139 months (240-101) at 10% p.a. which will give him Rs. 38,22,945 at maturity which is Rs. 1,91,428 more than option 2.
In such a scenario Mr. A is better off in Option 1 which is increasing EMI to Rs. 15,000.
But what if the rate of return on his investment changes?
Let’s assume investment rate of 12% p.a. instead of 10% p.a. (everything else remains the same)
| Option | EMI | Loan Completed in period (Months) | Investment | Investment Rate | Tenure of Investment | Future Value of Investment |
|---|---|---|---|---|---|---|
| 1 | 15,000 | 101 | 15,000 | 12.00% | 139 | 4,334,677 |
| 2 | 9,984 | 240 | 5,016 | 12.00% | 240 | 4,614,004 |
| Excess value of investment by Investing Surplus | 279,327 | |||||
If we analyse it carefully we can see that just by changing the investment rate from 10% p.a. to 12% p.a. Mr. A’s decision regarding increasing EMI changed to investing the surplus amount because it is giving him higher maturity amount by Rs. 2,79,327.
Why did this happen?
In the 1st scenario his investment rate is less than his rate of interest being charged on the loan which means he is earning interest on investment at lesser rate while paying higher interest on his loans, so its better to increase EMI and pay off loan ASAP.
In the 2nd scenario his investment rate is more than rate of interest charged on the loan which means he is earning interest on investment at higher rate while paying lower interest on his loans, so its better to invest surplus amount.
By now you might feel that all the calculations involved here are too much complicated, but do not get carried away by this. All you need to do is remember 1 simple rule: If you can earn higher rate of return on investment than what you pay as interest on loan, it would be always be better to invest the surplus amount rather than paying higher EMI.
If you are still feeling confused you can always contact your financial planner to help you solve your query and if you don’t have financial planner you can contact us at info@personalfn.com
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