Prepay home loan rather than invest in FDs

If the post-tax return from any fixed-income instrument is lower than the interest you pay on your home loan, prepaying the loan is the smarter option

The State Bank of India (SBI) raised its fixed deposit (FD) rates by 10-50 basis points (bps) recently. This was soon followed by several banks such as ICICI Bank and Punjab National Bank raising their marginal cost of funds-based lending rates (MCLR) by 10-20 bps. Both fixed-income investors and borrowers need to adapt to what appears to be a decisive turn in the rate cycle.

According to experts, liquidity within the banking system has tightened. Inflationary pressures, the government exceeding its fiscal deficit target, and the US Fed signalling at least three rate hikes this year are responsible for rising interest rates. The 10-year government bond is currently at 7.74 per cent, up 133 basis points from its low of 6.41 per cent on July 24, 2017. With banks finding it tough to garner deposits (investments are going into other higher-yield instruments), they had no option but to raise rates.

The increase in FD rates is good news for retirees who depend heavily on them. But according to Mumbaibased financial planner Arnav Pandya, “Interest rates on FDs are still not attractive enough.” Other options, he says, can offer higher returns. These include the 7.75 per cent government bond, tax-free bonds available in the secondary markets, long-term bonds from non-banking financial companies (NBFCs) with a three-seven year tenure (that can offer 7.5-8 per cent), and debt mutual funds. If at all you invest in fixed deposits, go for a tenure of six-nine months. “When these deposits mature, roll over into new ones offering higher returns, assuming interest rates continue to climb,” says Pandya. If you invest in debt funds, put 70-80 per cent of your money in shorter-term funds, and the balance in dynamic bond funds, where the fund manager will take care of duration risk.

Other advisors, too, don’t favour FDs. “Post-tax, the returns from FDs are paltry for people in the 20-30 per cent tax bracket,” says certified financial planner Pankaaj Maalde. According to him, investing in debt mutual funds for a three-year or longer horizon is a better option because of the indexation benefit. Among fixed-income alternatives, he likes fixed maturity plans (FMPs). “To avoid the volatility caused by rising rates, you can go for a threeyear FMP. Those that invest in AA+ paper can give you 7.5-8 per cent return. If you invest now for slightly more than three years, you can get indexation benefit for four years,” Maalde says.

Home loan rates, too, are set to climb. New customers will have to pay a higher rate right away. For older customers, the new rates will kick in once the reset date arrives. The latter should ensure that their loan is linked to the MCLR and not to the base rate, and that they are paying the lowest rate available. “After the reset date, existing borrowers should compare their rates with those being offered by other banks and NBFCs and calculate the potential savings on transferring. If they are substantial, go for the balance transfer option,” says Naveen Kukreja, Chief Executive Officer and cofounder, Paisabazaar.com.

Second, whenever you get a windfall, consider part prepayment of the principal. “It doesn’t make sense to invest in those fixed-income investments where the post-tax returns are much lower than the 8.5 per cent or so you are likely to be paying on your home loan,” says Maalde. If you have a home loan of more than ~3 million (~6 million in case of a joint loan, assuming 20-year tenure and 8.5 per cent interest rate), again prepay the loan since the maximum exemption you can get annually on interest repayment is ~200,000 (~400,000 in a joint loan).