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Loan me a house
A N Shanbhag |
June 14, 2003 13:16 IST
If you want to buy a house, you have two options. Either take a loan or use your own cash. Most people can't afford an outright purchase.
However, even those fortunate few who have the wherewithal to buy a house, should take a loan. Let's see why.
Well, for starters, interest outgo on the loan up to Rs 150,000 is tax deductible. Moreover, the capital repayments are eligible for Sec. 88 rebate upto Rs 20,000 within the overall general limit of Rs 70,000.
Now, if one were to use one's own funds, one wouldn't get these benefits. There are absolutely no tax benefits available for someone who wants to buy his property outright without taking a loan. This does seem a bit unfair, but that's the way it is.
Now, taking a step further, how much loan should you take? If you take a loan, you pay a higher rate of interest than you earn on your own funds.
So should you use your funds to buy the house? In that case, you lose the tax advantage.
Therefore, you have to weigh the benefit of the tax advantage of taking a loan against the loss due to higher interest outflow.
Obviously, there is a break-even point which can help you in arriving at the optimal mix. The answer would of course depend upon variable parameters like the interest rate on the loan and what your own funds earn outside.
Let us look at an example.
We assume that one Mr Mistry has taken a housing loan @10 per cent p.a., whereas his own funds earn 7 per cent p.a. (after-tax). His tax rate is 30 per cent.
The premise of the calculation is one's own funds are freed up to the extent of the loan taken.
In other words, if Mr Mistry were to take a loan of Rs 15 lakh (Rs 1.5 million), it basically means that his personal funds of Rs 15 lakh are available to be invested elsewhere. The comparison is done based on these figures.
It is assumed that the loan taken is Rs 15 lakh. The term is for 15 years. At an interest rate of 10 per cent p.a., the EMI works out to Rs 197,211. For simplicity, annual figures are taken.
In actual practice, EMIs are paid monthly. The total interest paid out for the first year is Rs 150,000. The closing balance for the first year is Rs 15 lakh less the capital repaid during the year.
Since a loan of Rs 15 lakh has been taken, Mr Mistry can invest a similar amount as he pleases.
These funds (it is assumed) earn an after-tax interest of 7 per cent p.a. Therefore, the interest received for the first year would be Rs 105,000.
What about the tax break on interest paid? Taxes saved is money not paid, i.e. it is money earned. At a 30 per cent tax rate, the advantage works out to Rs 45,000 and so on.
The inflows are the interest earned and the tax saving on the interest paid, whereas the outflows are the interest paid itself as well as the capital repayment.
We can come to the conclusion that were Mr. Mistry to earn 7 per cent from his funds in the market, he would be indifferent to using his own funds for the property or taking a loan. In other words, the break-even point in this case is 7 per cent p.a.
In other words, if Mr Mistry were able to earn 8 per cent p.a. on his funds, he should take a loan.
If the revised numbers are plugged in the spreadsheet, one finds that Mr Mistry would benefit by about Rs 300,000 by opting for the loan.
What if he were to earn just 6 per cent p.a.? In this case, by taking a loan, he would lose around Rs 250,000. So you see, this is a very powerful tool for every potential homeowner to determine the extent he should leverage himself.
You may have noticed that I started with saying that there is a tax advantage by way of rebate also, the same is not accounted for in the computations.
The reason is that the Sec. 88 rebate is not exclusive to the loan instalments. One can avail of the rebate otherwise too by way of investments in PF, PPF, LIC.
Also earlier, interest from other avenues like MFs etc., used to be much higher than what was available from avenues u/s 88.
Now, the rate of PPF (8 per cent tax-free) is higher than the taxable rate available from other avenues. Therefore, one should invest in PPF just for the interest, even if the limit of Sec. 88 has been reached.
Mr Mistry happened to be in the 30 per cent tax zone. If he were in the 20 per cent tax zone, he would need to earn 8 per cent p.a. and if he were in the 10 per cent tax zone, his funds would need to earn 9 per cent p a to break even.
Basically, what these calculations throw up is nothing new. It is just restating the obvious but in terms of cold numbers.
The greatest advantage of taking a loan emanates out of the tax break on interest. It is in the interest of the investor to maximise this tax break. Using own funds results in foregoing the tax advantage.
Also note that the ceiling of Rs 150,000 on interest is only in the case of self-occupied property. In the case of let out property, there is no ceiling on the interest deduction i.e. full interest paid is deductible.
In this case, obviously, taking a loan would be advantageous. There is no question of using one's own funds.
If you are not in a position to use your own resources, then by all means avail of a loan. Interest rates are perhaps at their lowest and there is no better time to take a housing loan than the present.
Now for those of you who have your own resources and are wondering how much of it should you use to part-finance the house.
The greatest advantage lies in taking that much loan which makes one pay an interest of Rs 150,000 during the first year.
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