Should you prepay your loan or invest the money instead?

Prepaying is a guaranteed return

Every rupee of principal you repay early stops earning interest for the lender. So prepaying a loan charging, say, 9 percent is equivalent to earning a guaranteed 9 percent on that money, with no market risk. That is the benchmark any investment has to beat, after tax, to be worth choosing instead.

The interest saving is greatest early in the loan, when most of your EMI is interest, and shrinks as the balance falls.

Compare like with like

Investments are uncertain and taxed, so compare the loan rate to a realistic, after-tax expected return, not to the best year you can remember. A safe option such as a fixed deposit earns interest that is taxable at your slab rate, so its after-tax return is often well below the headline rate, and below what you would save by repaying a loan of a similar rate.

Market investments such as equity funds may offer higher expected returns over long periods, but not in a guaranteed way, and the returns can be negative in any given year. If you would be uncomfortable seeing the investment fall while the loan keeps charging interest, that is a reason to prepay.

Factors that tilt the decision

• High-interest debt first: personal loans and card balances almost always deserve to be cleared before investing.
• Tax benefits: deductions on a home loan reduce its effective cost, and can make investing more attractive than prepaying a home loan, depending on your regime and limits.
• Liquidity: money you prepay is not easily available again. Keep an emergency fund before putting extra into a loan.
• Prepayment charges: floating-rate loans to individuals generally have none, but some other loans do, so check.
• Time horizon: the longer you can invest, the more equity-type investments can outpace a moderate loan rate.

How to prepay

When you make a part-prepayment, ask the lender to reduce either the tenure or the EMI. Reducing the tenure usually saves more interest overall. Reducing the EMI eases your monthly cash flow but saves less. Use the loan prepayment calculator on Truely Money to see the difference for your own numbers.

A practical middle path

You do not have to pick one. A common approach is to build an emergency fund first, clear any expensive debt, then split extra money between prepayment and long-term investing according to how your loan rate compares with your expected after-tax returns and how you feel about risk. This is general information, not personal financial advice.