Should you invest in tax-free bonds or prepay home loan?

By Narendra Nathan, ET Bureau | 21 Oct, 2013, 08.00AM IST

The market is flooded with taxfree bonds. Besides the three existing offerings (see table), the National Housing Bank is also expected to hit the market soon.

These are compelling investment options because the tax-free interest rates offered are very high and almost comparable with the pre-tax rates on bank fixed deposits.

The decision may not be that easy for those with a home loan to pay. The common refrain is that if there is any surplus money, shouldn't it be used to prepay the loan? Most borrowers may opt to prepay their loans than invest in tax-free bonds. If you are faced with the same dilemma, consider these factors before you decide.

Look at prepayment as an investment

Much of the confusion gets cleared if you see debt prepayment as just another investment. If you prepay Rs 1 lakh of a personal loan which was charging you an interest rate of 15%, you save Rs 15,000 in interest per annum.

And since money saved is money earned, your Rs 1 lakh will effectively earn you Rs 15,000 in a year. That's a good return and should be the first option for anybody with surplus cash. Evaluate your debts on the basis of the interest you are paying and start with repaying the costliest ones.

The credit card balance and personal loans should be the first in your cross-hairs. It doesn't make sense to keep money in a fixed deposit that fetches only 9% when you have a credit card outstanding with interest cost of around 42% and personal loans with interest cost of around 15%.

But you may also encounter situations where the loans are cheaper than what your investments can earn. That's when you should stop prepaying the loan and start investing. "Follow the simple rule that the return from the investments should be more than the interest on the loans," says Jaya Nagarmat from Investor Shoppe.

A small caveat here: You must also consider the risks involved in the investments when you make the comparison. You should only consider relatively safe investments such as bank fixed deposits and bonds.