Most Indian savers are caught between two acronyms – EMI and SIP. EMIs or Equal Monthly Installments are the payments you make on your home loan, if you have one. SIP or Systematic Investment Plan is a technique of investing in mutual funds. EMIs include both principal repayments and interest payments. When you receive a salary hike, bonus or inheritance, the question keeps popping up – reduce EMIs by paying off home loan or increase wealth by ramping up SIPs?
The answer depends on three factors:
Home Loan Interest Rate v SIP rate of return
Your home loan interest rate is the ‘cost of money’ and your SIP return rate is the ‘return on your money’. However, a home loan interest is fixed and unavoidable whilst an SIP return depends on market performance. So the answer isn’t as easy as saying – ‘I pay 9% interest on my home loan and earn 14% on my small-cap fund.’ That said, if there is a yawning gap between the two rates, you could use it as one of the points on which to base your decision.
If you invest in long-term debt mutual funds rather than equity mutual funds, rising interest rates directly affect your returns. Every percentage rise in interest rates will pull down your debt fund return. This effect is highest in Gilt or Income Funds. On the other hand, liquid or ultra-short term debt funds will suffer the least damage and eventually start to yield higher returns in sync with higher interest rates.
Your Tax Slab
Home loan principal repayments are tax deductible under Section 80C up to Rs 1.5 lakh per year. Contributions to ELSS (tax saving) mutual funds are also tax deductible under Section 80C up to the same amount.
However home loan interest payments are also tax deductible up to Rs 2 lakh per annum under Section 24B of the Income Tax Act which is over-and-above what you get with SIPs. So should you keep a home loan of Rs 20 lakh to get this benefit at roughly Rs 2 lakh interest per annum? Not quite. The interest component of your EMI is largest at the start of the loan and falls steadily as you reach the end of the loan term. Use our EMI calculator to see how this works. You can also use our SIP calculator to figure how much your funds will grow to at different rates of interest.
So how do you integrate these two factors – interest rate and tax benefit? Think of it this way, when your interest payment becomes tax deductible, the ‘effective interest rate’ goes down in proportion to the tax amount. For example, if you are paying interest of 10% and are in the 30% tax bracket, your effective interest rate becomes 7%. Similarly if you are paying interest of 12% and are in the 30% tax bracket, your effective interest rate becomes 8.4% (30% of every rupee in interest gets shaved off).
- Your liquidity needs
The desire to have a certain amount of money in readily accessible form is a major factor in this decision. A lot of life-events can trigger the need for cash from accidents to sickness to undertaking major repairs in the home. Some people see paying off a home loan as reducing this liquidity below their comfort levels. However, remember that cash in the savings account or cash sitting at home earns between 0-4% while your home loan is easily costing you upwards of 8%.
Several banks also offer overdraft or ‘OD” facilities that allow you to pull out more money than you have, for your emergency or short-term needs. These become ‘automatic loans’ and carry a rate of interest. However the interest rate meter only starts running if you withdraw more than your bank balance and stops the moment you pay it back. It may be a better idea to set up an OD facility on your account rather than building up cash balances by not paying back your home loan. (Also read: Loan against securities offers credit on tap, and it’s cheap)
Both interest rates and SIP returns are constantly changing. Your decision must hence depend on how you expect these two figures to move, rather than where they are now.
Over the past few months, interest rates have begun rising, reversing a steady decline since 2014. On the other side, mutual fund returns have also started to taper off. If you expect these trends to continue, paying off your home loan will be more attractive than topping up your SIP.