IT'S that time of the year again. Your annual incentive should come rolling in just about now making you the happiest person on earth. You start dreaming ways you can invest it so that it builds up to a magnificent corpus that you can spend on a month in Costa Rica far away from your boss or the beer festival in Germany, far away from your wife.

And then reality comes crashing in. You have a gigantic home loan hanging over your head like a sword which you feel you must pre-pay to avoid that outrageous interest you are paying. But should you feel guilty about not pre-paying your loan? Experts say, not really.

There are a lot of people like you who are pondering this decision. Many organisations today, pay out incentives based on quarterly performances. In such a scenario, employees are faced with a sudden lumpsum in cash, once every three months. And since most people today have some sort of borrowings, the decision is usually to make a choice between prepaying a loan or making an investment.

Experts say that there are three factors that will contribute towards this decision

• Your age
• Your risk taking capacity
• And the interest rate of the loan
  

Says Karthik Jhaveri, Director, Transcend Consultants, "If you are under 45 and have the capacity to hold up to 80 per cent in equity in your portfolio then your returns would be at least 12 to 13 per cent. If the loan cost is less than that, it would make sense to keep the loan."

However, for a risk-averse investor, the choice is difficult. The maximum assured fixed return he can get is 8 per cent that postal savings offer. In such a case, it would be better to repay the loan that costs 10.5 per cent. However, for such people, Jhaveri recommends a look at loan refinancing that is shifting from a high interest rate loan to a relatively lower interest rate loan.

It is also important to make a distinction between good debt and bad debt. Jhaveri explains, "Apart from interest rate, you must also look at how much debt and what kind of debt you have. Ideally, out of your total monthly cash flow, not more than 20 to 30 per cent should be towards debt repayment. If you have exceeded that limit, it is better to repay your loan even if the interest rate is very low." This obviously also means that you should pay off your credit card dues and personal loans that can cost anywhere between 20 to 40 per cent in interest.

So, the rule seems simple. If the returns you can make on your portfolio are more than the interest outgoing on the loan, it would make sense to keep the loan and continue investing. But there's a lot more to it than that simple arithmetic. There are tax implications for home loans, pre-payment penalties and so on. This adds to the cost of the loan. Most banks levy a pre-payment penalty of 2 to 3 per cent on their loans. That means, if you pay your loan or part of it in advance, you will have to pay a penalty of two per cent on the outstanding amount.

So weigh your options carefully before rushing to pre-pay. Taking off to Costa Rica via Germany might just be a better idea – leaving your boss, wife and loan behind!

Disclaimer: While we have made efforts to ensure the accuracy of our content (consisting of articles and information), neither this website nor the author shall be held responsible for any losses/ incidents suffered by people accessing, using or is supplied with the content.