Repay the loan or invest the bonus?

Many experts would recommend our priority should be to pay off high interest debt. Needless to say, paying off debt will provide you with peace of mind. It will also help you free up funds for other obligations/goals. Here’s how you can use your surplus cash smartly. 
Jan 2023
4 mins read
Prepaying principal
Paying off a home loan at the earliest should be treated as a mind game and not a numbers game as several surprises— job loss, demise of the sole breadwinner, serious illness, etc.—can cause trouble during the 10–15-year loan period.
When you prepay a part of the loan, it goes towards the principal payment. The moment the principal comes down, so will the interest cost. Paying off your home loan early can save you lakhs of rupees over the loan duration. You will have the extra money to spend on other things because you are no longer making monthly home loan payments. You may, for example, utilise the additional funds to pay for your child's college tuition or to prioritize goals like retirement.

Retire high interest debt
A bonus or acquisition of sudden wealth can also be effectively used to pay off high-interest debt which can help clear finances for other expenses. The biggest advantage of paying your debts early is you stop paying the interest. Over the longer repayment tenure, you end up paying a high-interest amount. Hence, repaying the loans early would save interest. Clearing off the dues by repaying them as and when possible reduces your financial burden and gives you peace of mind.

Benefit of prepayment
When you make a prepayment on your loan, it reduces the outstanding principal amount. This is critical as the following month's interest will be computed solely on the leftover principle amount, which has two significant consequences. In the next EMI, there will be one lower interest component and two higher primary components. This can significantly cut the interest component for the remainder of the loan's tenure while also allowing the principal to be repaid more quickly. As a result of your prepayment, you will be able to close your loan considerably sooner than you anticipated.
Assume you have a loan of Rs. 20 lakh with 20-year tenure paying interest of 7.5%. Your EMI is Rs. 16,111 per month. You end up paying Rs. 38.7 lakh at the end of 20 years, with interest component of roughly Rs. 18.7 lakh on a loan of 20 lakh. If we look at this scenario, you are paying almost the same amount as principal as interest.

Scenario 1-Home Loan with Rs. 20 Lakhs

Let us look at another example. Assume you take a 25 lakh home loan with a 20-year repayment period at 8%. Your monthly mortgage payment is Rs. 20,911. Prepaying a lump sum of 5 lakh after 12 months saves more than 12 lakh in interest during the tenure of the loan. If you are nearing retirement, you could prepay your home loan to minimize liabilities and enjoy a more tranquil retirement.

Scenario 2 – Home loan Rs. 25 Lakhs

Alternatively, instead of prepaying loan, you can invest surplus cash to make up for the interest paid on your loans or create corpus for exigencies or invest for long term goals.

Create emergency fund
Bonus can be used to create an emergency fund that can help if you were to face an unexpected and costly medical issue or are unable to work for any reason. Building an emergency fund will help you prepare for life’s unforeseen exigencies.

Invest for long term goals
Investing the bonus or surplus cash can help you reap significant benefits in the years to come. Your bonus would be used to fix the investment gaps in your financial plan. Most of our savings can be used for long-term goals such as retirement, kids' education, and so on.
Investing the surplus cash can help you reach your goals faster. Bonus can be partially used to build a corpus for a down payment to purchase a house. Further, one can make his/her money work for by investing early and taking advantage of compounding benefits. Assuming you invest Rs. 5 lakh lumpsum you would accumulate Rs. 21.57 lakh in 19 years, assuming 8% CAGR. This shows that you recover your entire interest component paid to bank. However, the key aspect here is that you should be able to hold on to this investment for such a long period.

To conclude, the decision to prepay the principal or investing the same would depend on your individual goals, circumstances and financial discipline.
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