- Before prepaying your home loan –
Most of us are averse to being debt ridden. A loan (of any type) is a debt that one would typically want to repay at the earliest (preferably prepay i.e. pay before it’s due). However, a home loan should not be considered in the same light as a personal loan, car loan, etc. A home loan offers a number of benefits which may make prepayment unbeneficial.
Prepayment is a facility which allows you to repay your housing loan (in part or full) before the completion of your loan tenure. Usually, customers opt for prepayment when they have surplus funds.
Important factors to be considered before deciding to prepay your housing loan.
Before deciding to prepay your housing loan...
- Avoid getting funds-strapped
- Consider income from investments
- Keep in mind the stage of the loan
- Keep in mind loss of tax benefits
- Check if you will have to pay prepayment charges
Before considering prepayment of your housing loan, you need to ensure that you have sufficient funds for your financial goals such as marriage, travel abroad, etc. You should avoid being in a situation where you have overextended yourself to prepay your home loan and, as a result, are funds-strapped when you need to meet a financial goal. Moreover, you also need to ensure that you have surplus funds available for medical emergencies, or unforeseen events such as job loss.
Income from investments
The cost of prepayment should also be compared with the returns that can be earned from investments. If you have the opportunity to earn returns which are higher than the home loan interest, then it is better to invest the surplus funds rather than using the same to prepay your home loan.
A home loan is a long duration loan; in order to make an ‘apples-to-apples’ comparison of your home loan cost vis-à-vis a comparable investment, equity investment should be considered. Equity investment is a long term investment where the risk reduces in proportion to the period of investment, i.e. the longer you hold your equity investment, the lower will be the risk.
Over the last 15 years, the BSE Sensex has given annualized returns of about 15%. Considering home loan interest of 9%, indicated below is a comparison of cost of your home loan vis-à-vis returns from equity investing over the long term.
|Home loan interest rate||9%|
|Tax saving (30% of 9%)||2.7%*|
|Effective rate of interest||6.3%|
|*Assuming the highest tax bracket; in case of let-out property, full interest amount is allowed as exemption; in case of self-occupied property, the tax exemption on interest is up to Rs. 2 Lakh. Tax saving on principal repayment (available under section 80 C) is not considered in the example; this will further reduce the cost of the home loan|
|Average annual returns from equity||15%^|
|Post-tax returns from equity investment||15%|
|*Average annual returns of the BSE Sensex over the last 15 years - www.bseindia.com|
In the scenario given above, the return on investment is higher than the effective rate of interest on the housing loan. Therefore, in such a case, investing the surplus funds is more fruitful than prepaying the housing loan.
Stage of the loan
The main benefit of prepayment is the reduction in interest outflow. The interest component in the EMI is highest during the initial stage of the home loan. Therefore, prepayment of loans in the mid-to-late stage may not give you the full benefit of saving on interest. In such cases, it is prudent to invest the surplus funds.
Housing loans are easier to service – the interest rate on home loans is generally lower than the rate of interest charged on other loans such as personal loan or credit card loan. Therefore, if you want to reduce debt, it is better to prepay high interest-bearing loans on priority basis (as against housing loans which carry a lower rate of interest).
Tax deduction for home loan
You are entitled to claim tax exemption of up to Rs.1.50 lakh per financial year on repayment of principal amount of housing loan. You can also get tax exemption on interest paid on housing loans (full interest amount is allowed as exemption in case of let-out property, whereas in case of self-occupied property, the exemption is up to Rs.2 lakh). Moreover, with the government’s focus on ‘housing for all’, the tax incentives on housing loans may increase over time. On full prepayment of your housing loan, you will no longer enjoy these tax benefits; in case of part prepayments, you will get lower tax benefits.