Prepay Loan or Invest?

The 10-second version

Extra cash can either prepay a loan (guaranteed “return” = saved interest) or invest (uncertain, but potentially higher return). The rational choice is to compare the after-tax loan rate with your expected after-tax investment return, adjusted for your risk appetite and liquidity needs.

Core idea in one line

If your loan costs more (after tax) than you can reasonably earn (after tax), prepay; otherwise, invest.

Step 1: Calculate your post-tax loan cost

Start with the loan’s interest rate, then adjust for tax effects:

• Home loan with tax deduction: Effective rate = interest × (1 − tax shield %).
• Personal/auto loans: No deduction → effective rate = stated interest rate.
• Business loans: May be deductible against business income (check rules).

Example: A home loan at 9% with tax benefits lowering effective cost to ~6.5% post-tax.

Step 2: Estimate expected post-tax investment return

Think in terms of realistic, long-run expected returns, not best-case scenarios:

• Equities: 10–12% nominal pre-tax long-run, but volatile; post-tax depends on capital gains/dividends regime.
• Debt funds/bonds/FDs: 5–7% nominal, taxed per slab or at capital gains rates.
• PPF/EPF/retirement vehicles: 7–8% with EEE (tax-free) status in India.

If expected post-tax return > loan cost by a margin (say 2–3%), investing may make sense—provided you can tolerate volatility.

Worked example

You have ₹5 lakh spare. Loan: 9% interest, no tax benefit (post-tax cost = 9%). Investment option: equity index fund with expected 11% pre-tax return, 10% post-tax.

• Prepay loan: Guaranteed 9% return equivalent (interest avoided).
• Invest: Expected 10% but uncertain. Bad sequence of returns could leave you behind.

Here, spread is small (10% vs 9%); for risk-averse, prepayment dominates. For aggressive investors, investing may still appeal.

Pros & cons

Behavioral dimension

Not all decisions are about spreadsheets:

• Debt-free mindset: Some value the psychological relief of prepayment more than marginal returns.
• Liquidity comfort: Investments remain accessible (subject to market/tax), whereas prepaid funds are tied up in the house/loan.
• Discipline risk: If investing means you might later redeem early or mis-time markets, the theoretical edge may vanish.

Hybrid strategies

You don’t need to choose all-or-nothing. Possible blends:

• Split approach: Use half to prepay, half to invest.
• Trigger rule: Prepay aggressively if loan rate >10% or market valuations stretched; invest otherwise.
• Systematic prepayment: Like an SIP in reverse: prepay a fixed amount extra each month, while still investing elsewhere.

When prepayment shines

• High-cost debt (>10–12%) with no tax benefit (personal/credit card loans).
• When close to retirement and prioritizing stability over growth.
• If risk appetite is low and being debt-free improves peace of mind.

When investing shines

• Low-cost, tax-advantaged loan (e.g., home loan at 6–7% effective) and long horizon.
• Strong discipline to stay invested through volatility.
• Higher expected returns from tax-efficient instruments (equity, retirement funds).

Five-minute decision framework

1. Compute post-tax loan rate: ____%
2. Estimate post-tax investment return: ____%
3. If loan rate > investment return → prepay.
4. If investment return exceeds loan by 2–3% and you have risk appetite → invest.
5. Otherwise, consider hybrid (split allocation).

Bottom line

Both choices can be right depending on context. Prepaying delivers a risk-free “return” equal to your loan cost and peace of mind. Investing offers growth but with volatility. The rational anchor: compare post-tax loan cost vs. post-tax expected return, then layer on personal comfort, liquidity, and discipline. Often, a balanced hybrid provides the best of both.