Mutual Funds: How effective is starting an SIP with only 10% of your EMI to offset interest costs?

By prepaying the loan early with mutual fund SIP, you save on the interest that would have been paid over the remaining tenure. Here's how

Saurav Basu
Published13 Jun 2024, 03:13 PM IST
Start an SIP for 10% of Your EMI to Repay Your Loan Early or Recover Interest Cost.
Start an SIP for 10% of Your EMI to Repay Your Loan Early or Recover Interest Cost.

Buying a home is one of the most significant financial commitments most people make in their lifetime. While home loans provide the necessary financial support to fulfil this dream, the interest component often becomes a considerable burden over time. However, there's an innovative strategy that can help mitigate these interest costs: investing a fraction of your home loan amount into a Systematic Investment Plan (SIP).

Understanding the mechanics

A home loan typically involves paying a fixed or variable interest rate over a tenure that can span decades. Over time, the interest paid can amount to a substantial sum. On the other hand, a SIP allows you to invest a fixed amount regularly into equity mutual funds, which historically have offered attractive returns over the long term.

The idea is simple yet powerful: by investing a certain percentage equivalent of your EMI into an SIP (eg: 10%), you can potentially earn returns that offset, or even exceed, the interest on your home loan. Here’s how it works:

Understanding the concept

Home loans typically have a long tenure, during which a substantial portion of the EMI goes towards interest, especially in the initial years. By investing a small portion of your EMI in a mutual fund through an SIP, you can leverage the power of compounding and potentially repay your loan earlier, thus saving on interest costs.

Example

Let's consider a practical example with the following parameters:

Home Loan Amount: 50 lacs

Interest Rate: 8.5% per annum

Loan Tenure: 20 years

EMI Amount: 43,391

Now, let's assume you start an SIP equivalent to 10% of your EMI amount:

SIP Amount: 5,000 per month

We'll assume an average annual return of 13% on the SIP investment.

Impact on loan repayment

To understand the impact on your loan, let's check the year in which the outstanding loan remaining is equivalent to the corpus generated through SIP over the years.

Calculating the mechanics

Post calculating: Approximately, after 14 years, the outstanding balance loan amount would be ~ 24 lacs, while your SIP corpus would have grown to around 24.5 lacs for the same period. Thus, by redeeming the entire corpus accumulated through SIP investments, you can foreclose the loan 6 years early.

By strategically using a mutual fund SIP, you can build a substantial corpus for significant prepayments, reducing both the loan tenure and the total interest paid.

Another way to look at this

Alternatively, if you continue your SIP for the entire loan tenure of 20 years, you can recover the interest cost. The total interest paid over 20 years for a loan of 50 lacs at 8.5% interest is approximately 54.14 lacs.

Home loan costMF SIP returns
Home loan amount (principal cost) Rs. 50 lacsTotal Invested Amount in 20 years 12 lacs
Interest rate of home loan 8.5% p.a.Expected annual return 13%
Tenure of the loan 20 yearsTenure for Investment 20 years
EMI Per Month Rs. 43,391SIP Amount: 10% of 43,391 = 4,339 (for simplicity, we'll round this to 5,000 per month)
Total Interest Payable 54.14 lacsTotal corpus accumulated 57.28 lacs
Total Payment (Interest + Principal) Rs. 1.04 crTotal Corpus (after deduction of Invested Amount) 45.28 lacs

Benefits

1. Interest Savings: By prepaying the loan early, you save on the interest that would have been paid over the remaining tenure.

2. Financial Freedom: Clearing your loan earlier than expected can provide financial relief and more disposable income for other investments or expenses.

3. Compounding Benefits: Regular investments in an SIP harness the power of compounding, potentially yielding substantial returns over time.

4. Flexibility: You have the option to either prepay the loan by the 14th year or continue the SIP for the full tenure to recover the interest cost.

5. Tax Benefits: Depending on the type of mutual fund, there may be tax benefits associated with SIP investments, further enhancing returns.

Key considerations

While this strategy holds promise, it is essential to keep certain factors in mind:

1. Risk Tolerance: SIPs in equity mutual funds involve market risks. Ensure your risk tolerance aligns with this investment approach.

2. Investment Horizon: The strategy works best over the long term, allowing compounding to maximise returns.

3. Financial Stability: Ensure that diverting funds into a SIP does not compromise your ability to meet home loan repayments and other financial obligations.

In conclusion, starting an SIP with just 10% of your EMI can be a powerful strategy to manage your home loan effectively. SIP corpus can help you foreclose your home loan early and help in saving on interest costs. Alternatively, continuing the SIP for the full loan tenure can help you recover the interest cost. This approach not only helps in managing your finances better but also provides financial flexibility and peace of mind in the long run.

By integrating disciplined investing with your loan repayment strategy, you can leverage the benefits of compounding to achieve financial stability and potentially clear your debt much earlier than planned, or recover significant costs associated with long-term borrowing.

Saurav Basu, Head – Wealth Management, Tata Capital Ltd

 

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First Published:13 Jun 2024, 03:13 PM IST
HomeMutual FundsMutual Funds: How effective is starting an SIP with only 10% of your EMI to offset interest costs?

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