Ratan Kumar Singh, aged 32, currently has a home loan outstanding of Rs 50 lakhs with a remaining tenure of over 20 years. At a floating rate interest of 10%, he pays a monthly EMI of over Rs 48,000 on the loan. His monthly take-home salary is around Rs 1 lakh and he just received a bonus amount of Rs 5 lakhs. With the EMI accounting for a substantial portion of his monthly salary, Singh laments that he is not able to spend on his dreams, like a trip to Europe or purchasing a new car. He is also aware that he is unable to save money for long-term needs like retirement. His asset allocation or net worth, is heavily skewed towards the house he owns.
Should you prepay your home loan?
For most people, the thought of owning a debt-free house is emotionally fulfilling, especially if the house is self-occupied. In Singh’s case, his housing loan is now five years old. While purchasing the house, he exhausted all his savings, to make the down payment. After his purchase, there was a slump in the housing market and his house was quoting at least 20% lower in the resale market than his original purchase price. Around three years ago, his company also started downsizing. Although it did not happen, a job loss at that point, would have not only meant a loss of monthly income, but also loss of the house due to non-payment of EMIs.
Emerging from this stressful period, he is now in a dilemma over whether to use his bonus to prepay his home loan or invest in financial products or spend it on his dreams. While the ideal action, would be to divide the sum towards each of his three goals, the actual allocation will vary, based on ground realities and each individual’s needs. “For some, paying off a home loan may not make sense, if it means putting all the income in one basket. If they do so, goals like children’s education, buying of a car or any other moveable asset, will be severely troubled,” points out Rajendra Joshi, CEO of SD Corporation.
How to calculate the benefits of prepaying a home loan
To decide whether to prepay a home loan or not, a simple question that borrowers need to ask themselves is: “Am I paying an interest on the home loan that is too high?” One can also compare the interest on the home loan after deducting the tax savings, with the expected returns from investing in long-term assets like equities or fixed deposits, to make a decision. While fixed deposit interest rates are known, they are often lower than the rate of interest on a home loan. On the other hand, equities could deliver higher returns but are uncertain at least in the short term.
Tax benefits on home loans
If the house is a self-occupied one, the interest component of the EMI paid during a financial year, is allowed as deduction under Section 24, up to a maximum of Rs 2 lakhs. For a person falling under the highest tax bracket, this provision can reduce taxes of around Rs 60,000 in a year. For first-time home buyers, there is an additional deduction of up to Rs 50,000 under Section 80EE, towards the interest component, over and above the deduction of Rs 2 lakhs. On the principal component of the EMI, Section 80 C offers benefits of up to Rs 1.5 lakhs. However, a person can use this section for other investments also, like PPF, ELSS, mutual funds, etc. In Singh’s case, his yearly deduction towards EPFO from his salary itself exceeds Rs 1 lakh and he can use the balance for other allowed instruments under Section 80 C.
Should you reduce the home loan’s tenure or the EMI?
Let us assume, Singh decides to use Rs 2 lakhs, towards prepayment of the home loan. If the tenure of the loan remains unchanged, his EMI would fall by around Rs 2,000 per month. However, if the EMI remains the same, the tenure of the loan would fall from 20 years to less than 18 years. So, while prepaying a home loan, one also needs to decide whether to reduce the monthly EMI or to reduce the remaining tenure of the loan. Reducing the tenure of the loan and keeping the EMI same, may be a wise approach. However, there will be a lesser amount to spend on a monthly basis, after paying the EMI. “If you plan on prepaying your home loan, the advantages include savings on interest expenditure, reduction of principal outstanding, financial stability and effect on credit rating. Moreover, many banks do not levy charges for prepayment. Hence, customers should choose carefully, before buying the home loan,” concludes Parth Mehta, managing director of Paradigm Realty.
The pros and cons of prepaying a home loan