To save tax which is better loan prepayment or ELSS?

The fiscal year is close to the end and many of you have surplus of Rs 1 lakh lying in bank account which you need to break to save tax. If you have taken home loan then you might be thinking whether you should repay your home loan or invest the money in an ELSS scheme?

On both home loan pre-payment and investment in mutual funds you get the same tax benefits. In case through out the year the total repayment that you do through monthly installments includes a principal repayment of close to Rs 1 lakh then, you won’t get any benefit as under Section 80C the investment limit is up to Rs 1 lakh.

The borrower who’s EMIs is largely made up of interest payment or a borrower with a relatively small loan where repayment of principal is far below Rs 1 lakh per year faces such situation.

If you repay your home loan the interest burden will get reduced but investing in ELSS will get you benefits of equities. According to Value Research conducted on February 4, over the past one year ELSS has posted 84.29% returns. When share market turns weak, ELSS becomes more attractive. Let us look at some details before reaching to final conclusion.

You can get tax relief in two ways on home loan prepayment. Under section 24 of the Income Tax Act, 1981, you get tax relief on interest component in the EMI up to the extent of Rs 1.5 lakh in a financial year.

The second one is on home loan principal repayment you get tax relief under section 80C up to Rs 100,000 per financial year. It is the same overall Rs 1 lakh limit as you get tax benefit for investing in ELSS scheme.

At the beginning of the fiscal the lenders issue the provisional statement going through this statement you can get an idea of how much principal and how much interest you are paying. This will be helpful for tax purposes. For several borrowers, the principal amount can be less than Rs 100,000.

Thus, borrowers have to invest the deficit in some other investing instruments such as public provident fund, mutual funds or life insurance to avail of full tax benefits.

Then prepaying loan is better option. As there is no cash return thus the borrower will save a large amount of interest on the pre-paid amount for the term of the loan. Earlier the conservative investors used to avoid taking loan to maintain their debt-free status. But the Rs 1.5 fiscal incentive a borrower gets can make investors think about this.

Veer Sardesai, a Pune-based financial planner points out, "If you have a very long-term home-loan outstanding, it makes sense to prepay the home loan. For loans outstanding with short timeframe, typically below five years, taxpayers may consider investing in ELSS."

Just looking a the fiscal incentive one should not think of prepaying the home loan if the cost of the home loan stands to be low than the post tax returns, in such case investing in ELSS is better option. If a pre-tax home loan rates is at 12% and the investor expects a post tax annualized yield of anything more than 12%, it is better to invest in ELSS.

However 12% might seem to be higher from the fixed income market, but equities are still better in the long-term. Vinod Ohri, president — equity, Gupta Equities says, "Investors can reasonably expect 15-18% returns per year from the equity markets over the next three years."

On the other hand bankers have imposed restrictions on prepayment. Some banks do not allow repayment in the first three years. Moreover some of them charge hefty pre-payment fee and processing fee and many banks do not bother if the borrower is repaying a small part of the loan though his surplus funds. While analyzing cost –benefit, consider these costs also.

After analysis ELSS returns look much better than the home loan repayment benefits. But home loan repayment is predictable whereas ELSS cannot always be value accretive- it is not possible to analyze the losses in extreme cases. As per the survey conducted by Value Research, the three years returns stand at 5.61% as on February 4, 2010.

According to financial analysts in the next credit policy review the rate can increase. Therefore, if you have the floating rate option and your bank follows the central banker, you might end up paying higher. In such a case it is better to repay home loan now so that impact can be minimized.