Should You Prepay a Loan or Invest the Money?
You get a bonus or some savings build up. One part of you wants to cut the loan, another wants to invest. There is no answer that suits everyone, but a clear way of comparing the two makes the choice easier. This is general information, not advice. You can see the effect of a part-payment on our loan prepayment calculator.
Key takeaways
- Prepaying a loan gives a certain return equal to the interest rate you avoid. Investing gives an uncertain return.
- Compare the loan rate with a realistic after-tax return, not the best case.
- Build your emergency fund before doing either.
Step 1: Emergency fund first
Money you may need within months should not go into a prepayment, because you cannot take it back out of a loan. It should not go into volatile investments either. Keep an emergency fund separate before you decide anything else.
Step 2: Compare rates honestly
Each rupee you prepay saves interest at your loan rate, with no market risk. Each rupee you invest might earn more, or less, or lose value in the short term. So the comparison is a sure return against a possible one.
Use a realistic return after tax and after costs, and be careful about extra risk. If your loan rate is higher than what you can safely earn, prepaying is the stronger choice. If you can reasonably expect to earn well above the loan rate over a long period and can handle the swings, investing may win. A gap of one or two percentage points is rarely worth the added risk.
Step 3: The effect of loan tax benefits
Prepaying reduces the interest you pay, so the Section 24(b) deduction on interest also falls. The old regime also allows principal repayment under 80C within the overall limit. If you have moved to the new regime, these deductions may not apply to you. Check the latest rules and your own situation before counting any tax benefit.
Step 4: Think about risk and flexibility
- A prepaid loan cannot be re-borrowed on the same terms. An investment can be sold if you need cash, though possibly at a loss.
- Sleeping better with less debt is a real benefit for many people.
- Some loans, such as car and personal loans, may carry foreclosure charges. Check your agreement.
Worked example (illustrative)
You have ₹5,00,000 spare and a home loan of ₹30,00,000 at 9% for 20 years. The EMI is about ₹26,992. If you part-pay ₹5,00,000 after 12 months and keep the EMI the same, the loan ends after about 165 months instead of 240, which is roughly 6 years and 3 months sooner. The interest saved is about ₹15.5 lakh.
Now compare that with investing the same ₹5,00,000 for 10 years. These return rates are assumptions only, after tax:
- At 7% a year it grows to about ₹9.8 lakh.
- At 9% a year, which matches the loan rate, it grows to about ₹11.8 lakh.
- At 10% a year it grows to about ₹13 lakh.
The investment only clearly beats prepaying if the after-tax return stays above the loan rate for long enough. Returns on market investments are not guaranteed and can be negative, while the interest saved on a loan is certain. Note that the two sums are not exactly like for like, because prepayment savings come over the loan's remaining life.
A simple decision checklist
- Do I have an emergency fund of several months of expenses? If no, build that first.
- Is my loan rate higher than a realistic after-tax return? If yes, lean towards prepaying.
- Can I stay invested for five years or more and accept losses along the way? If no, lean towards prepaying.
- Does the loan have prepayment charges? If yes, factor them in.
- Could I do both, for example part prepay and part invest? Splitting is a perfectly valid choice.
If you invest, a regular plan can also work. See what a monthly amount that grows each year can build with the step-up SIP calculator, or test a one-time amount with the lumpsum calculator.
Try the calculator
Loan Prepayment CalculatorLumpsum CalculatorStep-up SIP Calculator
Frequently asked questions
Are there charges for prepaying a home loan?
For floating-rate home loans taken by individuals, banks cannot charge prepayment penalties. Fixed-rate loans, car loans and personal loans may have charges. Check your loan agreement.
Is it better to reduce EMI or tenure?
Reducing the tenure saves more total interest. Reducing the EMI improves monthly cash flow but saves less.
Should I prepay a loan or build an emergency fund?
Emergency fund first. A prepayment cannot be taken back out of the loan when you need cash.
Does prepayment affect my tax benefit?
Interest you pay falls, so the Section 24(b) deduction on interest also falls. Check the latest rules for your regime.