You got a bonus. Do you prepay the loan or invest it? The answer is pure arithmetic — here's how to run it.
Why prepayment is so powerful early
Loan interest is front-loaded: early EMIs are mostly interest. A prepayment in year 2 kills principal that would have generated interest for the next 18 years. The same prepayment in year 17 saves a fraction of that. Rule of thumb: prepayments in the first third of the tenure deliver ~70% of the total possible savings.
Worked example
$250,000 loan at 6.5% for 20 years: EMI $1,864, total interest ~$197,000. Now prepay $20,000 once in year 2: total interest drops by roughly $38,000 and the loan ends ~2 years early. That single prepayment earned an effective 6.5% annual return — guaranteed, tax-free, risk-free.
Prepay vs invest: the decision rule
- Prepay if: loan rate > expected investment return (after tax). A 12% personal loan vs 8% expected market return? Prepay, no contest.
- Invest if: loan rate is low (say 4–5% mortgage) and you have a long horizon — markets have historically beaten that.
- Split if: rates are close. Half prepay, half invest — you get the guaranteed return and keep liquidity.
Also weigh the non-math factors: prepaying high-interest debt improves sleep; investing keeps cash liquid for opportunities. And check for prepayment penalties — some lenders charge 1–2%, which changes the math.
The 3-question decision framework
When the raw numbers are close, answer these three questions in order:
- Is your loan rate higher than your realistic investment return? Compare after tax and after fees. A 10% personal loan vs 8% expected market returns → prepay, no contest. A 4.5% mortgage vs 8% expected returns over decades → invest. If the two are within ~1%, move to question 2.
- Is your emergency fund full? Money thrown at an illiquid loan while you have no cash buffer is fragile. Fill 3–6 months of expenses first — size it with the emergency fund calculator — then decide.
- How much does the debt bother you? Guaranteed returns carry a psychological premium. If the loan keeps you up at night, prepaying a 6% loan instead of chasing an uncertain 8% is a rational trade — sleep has value.
Break-even math: a worked example
$200,000 mortgage at 6% for 20 years (EMI $1,433). You receive a $10,000 bonus. Two options:
- Prepay: principal drops to $190,000. Total interest falls from $143,887 to $122,483 — you save $21,404 and finish 21 months early. That is a guaranteed 6% annual return.
- Invest at 7%: $10,000 × 1.0720 = $38,697 — a $28,697 gain, roughly $7,300 more than prepaying.
Investing wins if you actually earn 7% every year for 20 years. Prepaying wins on certainty. The break-even expected return is roughly your loan rate — demand a clear premium above it before choosing market risk over a guaranteed return. Model your exact loan in the loan / EMI calculator and test both paths.
Prepayment strategies ranked
- Annual lump sum (bonus/tax refund) in the early years — biggest impact per dollar.
- Round up the EMI — paying $2,000 instead of $1,864 monthly shaves years off quietly.
- One extra EMI per year — on a 20-year loan, this alone cuts ~4 years.
- Biweekly payments — 26 half-payments = 13 full EMIs/year, same effect as above, automated.
Before you prepay, check this list
- Do you have a 3–6 month emergency fund? Prepaying into an illiquid loan while having zero buffer is dangerous.
- Any higher-rate debt? Kill the 22% credit card before the 6.5% mortgage — run both in the debt payoff calculator.
- Prepayment penalty in your loan agreement?
- Tax angle: in some countries mortgage interest is deductible, lowering the effective rate — factor that in.
Model your exact loan in the loan / EMI calculator and test different prepayment amounts in the early years — the interest-saved column makes the decision obvious.