Have some surplus funds and in two minds about how best to use it? Yes, you can invest in tax-free bonds offering attractive interest rates of about 8.7 per cent. But what about your home loan on which the interest rate has been galloping? We offer four tips on how to make the choice.

Suppose you have a joint loan of Rs 30 lakh at 10.5 per cent with a tenure of 20 years remaining.

Keep the EMI steady

You now have surplus funds of Rs 1 lakh and are in the 20 per cent tax bracket.

By prepaying Rs 1 lakh, you can reduce the monthly EMI by Rs 1,000 – from around Rs 30,000 to Rs 29,000. In this case, the term remains 20 years and the interest paid through the life of the loan works out to Rs 40 lakh.

However, if you pre-pay, but opt to retain the same EMI, the loan could be paid off in 18 years. Total interest paid then reduces to Rs 35 lakh.

The original loan would have incurred a total interest expense of around Rs 42 lakh. Prepaying and keeping the tenure at 20 years saves Rs 2 lakh compared to a saving of Rs 7 lakh if you reduce the tenure.

It helps to reduce the loan’s tenure because every month, a portion of the monthly payment goes towards paying down the principal.

The decreasing loan balance helps reduce the total interest cost.

Tax doesn’t matter

The interest paid on the home loan qualifies for tax deduction up to Rs 1.5 lakh per person. Thus, when you take on a 10.5 per cent loan, you may actually pay only 7.35 per cent, after availing the tax deduction in the 30 per cent bracket.

But no matter what your tax slab is, prepaying is the best option for you, rather than investing in a tax-free bond.

Over a 20-year period, income from the bond, which includes annual interest and reinvestment, works out around Rs 3.6 lakh. Prepayment provides a saving of around Rs 5 lakh in interest payments after accounting for taxes.

For someone in a 30 per cent tax bracket, income from the bond would be Rs 3.3 lakh and prepayment helps reduce interest costs by Rs 4.3 lakh. Hence, prepayment is better than tax-free bonds even for those in higher tax brackets.

When not to pre-pay

But there are certain situations when you must hang on and not prepay your loan. If you have just a few years left on your loan, you may be better off investing the amount, instead of prepaying.

For instance, for a ten-year loan, the bond investment offers Rs 1.2 lakh income, while repayment saves you Rs 1.4 lakh. Repayment is still slightly better, but the benefits decline as the loan period shortens. And what if interest rates come down? A comparison of the two options shows that you will be better off prepaying the loan, until the home loan rate falls to 8.5 per cent.

Anything lower and you must buy those tax-free bonds.