The interest rate cycle is finally on its way up thanks to multi-year high global and domestic inflation. To control inflation, like many other central banks across the world, the Reserve Bank of India (RBI) raised the repo rate by 0.40% on May 4, 2022 and hinted that more rate hikes are coming. The next rate hike will most certainly happen during the next monetary policy meeting of the RBI, which will culminate on June 8, 2011. Home loan borrowers, especially those who have taken the loan on floating rate basis, will have to bear the brunt as they would end up paying higher EMIs as the interest portion will go up sharply in coming months.
A good way to cope with higher interest outgo is to make partial prepayment and bring down the total loan outstanding amount. However, prepaying the loan may not always be an advantageous proposition for many borrowers. On one hand the interest rate on home loan is among the lowest (when compared to other loans) and borrowers get unique tax saving opportunities on both the principal and interest payment. However, this has its own limitations, and, in many circumstances, borrowers are better off by making partial prepayment of their home loans. Here is when making prepayment will work for you.
When annual interest payment goes above Rs 2 lakh
Majority of home loan borrowers typically utilise up to Rs 2 lakh deduction under section 24b of the Income-tax Act, 1961 on the interest payment of the home loan on a self-occupied house. In case of people falling either in the 20% or 30% income tax brackets, this deduction ends up giving annual tax saving of Rs 40,000 and Rs 60,000 respectively. So, even if they have surplus money, they can choose to invest rather than prepaying their loans as it would bring down their loan outstanding hence the interest outgo and tax benefit as well.
However, a rate hike may disturb the balance as they will end up paying more interest than Rs 2 lakh which will go to waste as it will not give any tax benefit. For instance, on a Rs 30 lakh loan at an annual interest rate of 6.75%, the total interest outgo in a year is Rs 2 lakh, however, if the rate goes up by 1%, then the total interest outgo will rise to Rs 2.3 lakh. So, the additional payment of Rs 30,000 due to the interest increases the cost of home loan without any tax benefit. Here, if you make partial prepayment in such a way that annual interest outgo reaches close to Rs 2 lakh then it would be efficient utilisation of the home loan.
“Existing home loan borrowers can use surpluses parked in low-yield fixed income products to make home loan prepayments. The interest rates charged on home loans are usually higher than the interest rates offered on most fixed income products,” says Ratan Chaudhary – Head of Home Loans, Paisabazaar.com.
In the above example a partial prepayment of Rs 4 lakh will bring down the total interest outgo within a year to around Rs 2 lakh which will enable the borrower to utilize the full interest outgo for tax saving. In case of higher loan outstanding borrowers, have to go for higher partial prepayments or make frequent partial prepayments to bring down the outstanding to a level where annual interest outgo is around Rs 2 lakh.
However, in case you are confident of generating higher return on surpluses than the enhanced cost of your home loan then you may not need to utilise the partial prepayment option. “It makes sense to keep a home loan that gives a tax rebate only if your savings or investment return (post tax) is higher than the post-tax return of the home loan. This can happen if you do the spreadsheet calculation and see the interest earned vs interest paid at a post-tax level,” says Malcolm Athaide, CEO-CoFounder, Agrim Housing Finance.
When 80C deduction is not fully utilised
While you may be getting complete deduction benefit on the interest payment if it is below Rs 2 lakh, however, there are many situations where the annual principal repayment remains much below Rs 1.5 lakh. For instance, on a Rs 25 lakh loan at an interest rate of 7.5% for a tenure of 20 year, the annual principal repayment is Rs 56,080. Any prepayment done over and above the monthly EMI amount is considered as repayment of principal and hence, it will be eligible for section 80C deduction.
In above example, you can get 80C deduction on Rs 56,080 for home loan principal repayment however, Rs 93920 of 80C deduction benefit will remain unutilised if you do not have any other eligible expense or investment under section 80C.
However, in case you have other 80C avenues like EPF, PPF, life insurance policies and school fee payment of around Rs 50,000 then you can make partial prepayment of Rs 43,920 to utilise the complete benefit of Rs 1.5 lakh deduction under section 80C.
In another scenario, if you do not have any other avenue to utilise the section 80C annual deduction limit of Rs 1.5 lakh, then making a higher partial prepayment will help you in increasing this deduction. So, if you make a partial prepayment of Rs 93,920 lakh, you can utilise the full benefit Rs 1.5 lakh of the section 80C deduction.
When no tax benefit is needed for affordable home loans
With standard deduction of Rs 50,000, section 80C deduction of Rs 1.5 lakh and other tax benefit like LTA and medical insurance many people with annual taxable income of around Rs 7-8 lakh will end up paying zero income tax and hence, they may not need any additional tax deduction on home loan interest payment.
Therefore, even in the affordable segment, prepayment may make sense for people who do not need home loan for tax saving. “In an ideal world for the affordable housing segment, if the customer is not availing of tax breaks, any low-interest income investments should be liquidated to prepay, or part pay the home loan,” says Athaide. Rising interest rate gives you a more compelling reason to consider partial prepayments.
However, if the surplus fund earning low yield is for your emergency needs then you should not touch this money. “Existing borrowers should not sacrifice their fixed income investments earmarked for emergency funds or for unavoidable financial goals. Doing so may force them to avail loans at much higher rates to deal with financial exigencies or for meeting their unavoidable financial goals,” Chaudhary.