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Prepaying home loan? Read this first!
Sunil Dhawan, Outlook Money | January 23, 2007
Is the EMI on your floating rate home loan heading up again and threatening to take a bigger bite of your monthly budget? The recent hike in the cash-reserve ratio of banks has made it even more likely.
ICICI Home Finance has already increased its interest rates. But this may not be a surprise for you anymore - you have seen your EMI increase steadily in the past one year. If not the EMIs, the tenure of your home loan might have increased. When the interest rates go up, banks first increase the tenure of loans. When the extension of tenure pushes the maturity of the loan beyond the normal retirement age of the individual, banks increase the EMI too.
Routes available to you
You have two options to deal with higher EMIs. One is the part repayment route, in which you pay off a lump-sum amount to bring down the level of instalments. This approach may nullify the impact of the rise in interest rate on your monthly budget by bringing the instalments down to the previous level.
The lump-sum amount you pay gets adjusted against the outstanding balance and this reduces your EMI. The rate of interest, however, remains at the new, higher level. But first, make sure there isn't a prepayment penalty associated with your loan. The other option is to ask your bank to switch over the loan to current interest rates for a new loan. Most of the time the rate would be lower than for old loans. This will suit those who are paying interest at the higher rate.
Before you choose your option, you should examine the alternatives and the costs associated with them. Debt can be difficult to handle. A period of indebtedness of 10, 15 or 20 years, clubbed with the uncertainties of job and life, create an uneasy situation. From a purely psychological perspective, therefore, it may be better to pay off one's debts.
Part repayment of loan
Developments such as windfall profits from the stockmarket, maturing of old investments, build-up of capital over the years due to increase in salary, or a bonus for both you and your spouse might prompt you to go for prepayment of your home loan.
When you prepay part of your loan, the amount you have to pay as interest comes down. But in the bargain, you also lose part of your tax break on the loan. Suppose, you are in the highest tax slab of 30.6 per cent and the interest on your home loan is 9 per cent. The tax break would be 30.6 per cent of your interest rate.
That comes to 2.7 per cent. So, the effective rate of interest on your loan would be the difference between the actual rate and the tax break, that is, 9 minus 2.7, which comes to 6.3 per cent. The effective rate of interest can be calculated in a similar manner for other tax slabs and loan interest rates too.
This would hold true only when the interest payment is within the 150,000 limit. The principal amount in the EMI gets tax benefit under section 80 C up to Rs 100,000, while the interest portion is tax-deductible up to Rs 150,000 every year.
The effective rate of interest is lower than the home loan rate because of the tax break on the loan interest. If, in the example we have taken above, you are able to invest your surplus funds in the market and earn more than 6.3 per cent after taxes, then you are probably better off with the investment. Pay off the loan rather than invest unless your return on investment is higher than the effective interest rate of the loan.
Figurewise. Now, let us look at the financial implications of this. This exercise would help you decide whether you should continue with your loan if you have the money and can repay it.
Assume that in August 2004, you took a loan of Rs 14,23,750 at 8.5 per cent for a period of 240 months at an EMI of Rs 12,356. There has been an upward movement in the rates since August 2004 and the current rate stands at 11 per cent.
As rates rose, the EMI was initially kept fixed, and the tenure was extended. When the tenure extension stretched the maturity of the loan beyond the retirement age, the EMI was hiked too.
The tenure that remains as of now is, say, 215 months, the outstanding balance is Rs 13,74,583 and the EMI Rs 14,675. To bring back the EMI to the original level of Rs 12,356, you will have to pay off about Rs 2,15,000.
You will need to consult your banker to work out the amount you will have to pay off in a given situation. In the example we have taken above, the overall savings in interest that will accrue to you because of the payoff is about Rs 2,78,051 (see table Reining in EMI: An Example).
This means that the total interest component of your payments to the bank from today works out to Rs 17,77,693. Understandably, the tax benefit on interest is higher in the initial few years and tapers off towards the end.
What to do. The risk-free return that you can generate from government-backed public provident fund is a tax-free eight per cent. If the effective rate of interest of your loan (after accounting for the tax break on the basis of your tax slab) is less than the return on investment that you can generate - eight per cent in case you go for PPF - it is better to invest.
The cut-off rate of home loan interest comes to 11.5 per cent: at interest rates higher than this, it makes sense to repay the loan, at lower rates, to continue (see table). The interest rate of 11.5 per cent yields an effective rate of 7.98 per cent after the tax break. Considering the overall limit of Rs 70,000 in PPF, you may opt for diversified equity mutual funds as well.
This strategy of prepaying the loan would appeal all the more to you if you want to live in a debt-free world and own a home. You will get to own the home earlier if you channelise your surplus funds towards prepayment of the loan. It is uncertain whether you will have such a surplus in the future.
Take the case of Abhash Veer Singh, 29, a manager in a Noida-based IT firm. He took a home loan three years back for 20 years. With rising rates, the tenure has increased to about 26 years. This is a major concern for Singh.
He wants the peace of mind of being debt-free and is looking to prepay his loan and reduce its tenure. For him, the money he would prepay is a saving and the tax advantage on it an incentive. He would be prepaying Rs 60,000 this year.
The prepayment can be a one-time affair or be at regular intervals. Investments like insurance qualify along with home loan principal prepayment for the tax advantage of up to Rs 100,000 available under Section 80 C. So the amount of principal you prepay should ideally be the difference between the limit of Rs 1 lakh and fixed obligations like insurance premiums.
The current home loan rate of interest is 9-9.5 per cent. If you have a home loan on which you are paying a rate higher than this, you may approach your banker to switch over your loan to the existing rate. This, however, comes at a cost.
For example, if the current flexible rate of a bank is 9.25 per cent, its old customers might be paying instalments at 11 per cent. They may have to shell out some percentage of the balance outstanding, say 1.75 per cent, and 12.24 per cent service tax on it to avail the current rate of interest. This rate will be the same as what new customers of the bank would be paying.
Figurewise. In the example that we had taken earlier, the cost incurred to switch over would be about Rs 27,000. The outstanding amount and the term of 215 months don't change, but the interest rate reduces to 9.25 per cent. The EMI, too, falls to Rs 13,111 and there is an overall savings in interest of about Rs 3,33,317 (see table).
What to do. There is strategy for availing the maximum benefit and getting the best of both the worlds. Get a fix first on the total amount of penalty from your banker in the switchover option. Deduct this amount from the cash available with you and prepay the balance.
Exercise the prepayment option first after taking into account the penalty to be paid. Then ask your banker for a switchover. As prepayment would have reduced your loan outstanding, the penalty of the switchover option would also be lower and you will be left with some of your initial surplus amount after both prepaying the loan and bringing down the interest rate by going for the switchover option. Do talk with your banker to carve out the best way as every case would have its own nuances.
It's a great feeling to own a house, and may would feel that the earlier the better. So the decision on the home loan does not have only a financial dimension, there is a psychological aspect too. A final suggestion: clear your non-constructive debts like credit card, car and personal loans before you focus on your home loan.