Should you pay home loan EMIs with mutual fund SWP?

Should you pay a big downpayment when buying a home on a loan or pay equal to the bank’s required margin? Since a home loan is one of the cheapest borrowing products, should you use the excess funds for prepaying the home loan or invest them in mutual funds for a higher return and repay the EMIs through its SWP?

Knowing how to effectively manage your fund can make your home-buying and home loan repayment journey easy. Several home loan borrowers struggle to pay home loan EMIs despite a good income. This is because they lack planning and strategy for handling debts in the long term. Using the Systematic Withdrawal Plan (SWP) in your mutual fund investments can be an effective tool that can assist in the timely repayment of home loan EMI. It is important to know how SWPs work and what are their pros and cons before you use them for repayment of your home loan EMIs.

What are SWPs?

“The SWP acts opposite to the Systematic Investment Plan (SIP). While SIPs help you invest systematically, SWPs help you liquidate the investment systematically to generate a fixed income on a monthly or annual basis. A fixed portion of your investment is liquidated and the proceeds are moved to your linked bank account. This gives you the needed liquidity and allows the remaining investment to grow. If your withdrawal rate is lower than the rate at which your investment is compounding, you will never run out of money,” explains Adhil Shetty, CEO, BankBazaar.com.

Experts point out that if you have accumulated corpus in equity funds, you can set SWP in a manner that matches your EMI obligation. Therefore, your repayment is taken care of by SWP while the rest of the money can continue to compound in equity markets.

Should you use the extra fund to invest in the mutual fund or clear the outstanding home loan?

Suresh Soni, CEO, Baroda BNP Paribas Mutual Fund, suggests, “It should only be pursued if you have a long horizon and are prepared to withstand some volatility in the interim. While home loan interest cost is spread evenly, equity returns can be lumpy and have a sufficiently long horizon of, say, 10 years or so. Over the last 10 years, Nifty 50 has grown at 14% CAGR, whereas typical home loan costs would have been 8-9% pa.” (Source: MFI Explorer, Bloomberg, as of 31st May 2024)

A home loan is a long-term borrowing tool with multiple high and low-interest rate cycles. If you have borrowed while the rates were low, your returns may not scale up when the rates go up, warn experts.

“It all depends on how expensive your loan is and how much can you earn by investing your capital. Typically, you need to earn additional returns of at least 4% CAGR compared to your loan rates to conserve your capital. More importantly, this difference in returns should continue for the entire lifecycle of your loan,” adds Shetty.

How does the SWP setup work for repaying home loan EMI?

In a SWP setup, to repay the home loan EMI, invest a lumpsum amount in the appropriate mutual fund schemes and start an SIP depending on your loan’s tenure and EMI size. Here is an illustration that shows the SWP set up to repay home loan EMI.

In this illustration, the borrower has to invest Rs 60000 through SIP along with a lump sum investment of Rs 35 lakh and withdraw money through SWP on a fixed date. If the home loan borrower gets a regular return of more than 11.45% on the investment, then the loan EMI can be repaid completely using this set-up.

It is important to remember that mutual funds are subject to market risks and investors may not always get a desired level of return. Consult a financial advisor before using the SWP setup for repaying the loan EMI.

Things to consider when creating a SWP to repay a home loan EMI

According to experts, the following are some important points to consider before creating an SWP for repayment of your home loan EMIs:

• The rate of withdrawal should be lower than the rate of growth. In a high-inflation country like India, a difference of 4% may not be sufficient. Aim for a 5-6% difference, if possible.
• Large withdrawals during the negative growth years would risk accelerating corpus exhaustion. Consider putting 1-2 years of income needs in the liquid fund as it would give you the required liquidity and prevent depletion in the bad years.
• Beware of the applicable tax rate. Tax on SWP transactions depends on the underlying asset class and investment tenure.

Ideal mutual fund investment combination for SWP set-up

“More than the rate of return, my focus would be on the rate of withdrawal. You may need 5-6% due to high inflation, therefore, you need the fund to grow at least 10-12% annually. Large-cap equities have delivered 14% average returns over the last two decades. The blend of growth and stability offered by an index fund, such as Nifty 50, would be preferable for many. You could use equities for growth, park short-term funds in a liquid fund and liquidate that through an SWP,” suggests Shetty.

Investors should periodically balance their portfolio for growth and liquidity and create the SWP from a stable fund, such as a liquid fund. SWP can be an effective way to earn a decent return on your money before you use it to repay the EMI on your outstanding loan. You must not rely completely on the SWP setup to repay the home loan. If you can repay your home loan EMI, you can consider the SWP option for additional benefits, such as comfort and ease of loan repayment.