When you buy a house through a home loan, lenders take into account your current income and accordingly, sanction the home loan, based on your eligibility at that point of time. With increase in income over time, one may be able to accumulate surplus funds. Such borrowers often face the dilemma of whether to use the surplus funds to prepay the home loan or invest the money elsewhere. The decision will depend on various costs and benefits involved in prepaying your home loan. Given below are some of the factors that borrowers should consider, before making this decision.
Factor future fund requirements before prepaying a loan
You should take the decision to prepay the home loan, only after taking into account the requirement of funds in the near future for any purpose, including contingencies. Home loans are available at relatively cheaper interest rates, compared to other loans like personal loans and gold loans. In case you need money in future, after having prepaid the home loan, you may have to borrow money at a far higher rate of interest in the form of a gold loan or personal loan. So, ensure that you have adequate contingency funds, before you opt to prepay your home loan partially or fully.
Check tax considerations before prepaying a loan
The decision to prepay a home loan, may also impact your eligibility to claim interest deduction under Section 24(b). In case the property is self-occupied, you are allowed deduction of only up to Rs two lakhs per year on the interest component. So, as long as any part prepayment does not bring the amount of interest below Rs two lakhs, it will not have any impact on your tax liability.
However, in case the property is let-out, the decision would be different. Earlier, the entire interest payment was fully tax deductible but from the current year and onwards, the total loss under the head ‘income from house property’, which can be set off against other income, would be restricted to Rs two lakhs for all the properties taken together. The unabsorbed loss (which arises due to interest on home loan) can, however, be carried forward for set off against income from house property, for eight subsequent years.
Processing charges for prepayment of home loans
Lenders may levy some prepayment charges and the quantum of such charges, will depend on the terms agreed upon, at the time of taking the home loan and will be as per the agreement executed by you. Such charges vary between 0-4 per cent.
As per a circular issued by the National Housing Bank, housing finance companies have been advised not to levy any prepayment penalty, if the home loans are under the floating rate of interest. In case of fixed rate home loans, the housing finance company still cannot charge any prepayment penalty, if the borrower has repaid from his own resources. ‘Own resources’ mean any source, other than by shifting the loan to another lender. Likewise, the RBI has also advised all banks not to levy any prepayment penalty, on floating rate loans. However for fixed rate loans, the banks can charge a prepayment penalty.
Lending institutions normally do not charge any prepayment penalty, if the amount prepaid during the year does not exceed a certain percentage of the loan outstanding, which is generally 25 per cent. Hence, if you are prepaying within the limit, you can do so, without having to pay any penalty.
Returns expected from alternative investment avenues
In case the returns expected on investments in alternative options, are similar to the interest on the loan, it is advisable not to prepay the loan. Bonds and bond fund schemes of mutual fund houses, are some avenues for deployment of surplus funds. The other alternative may be equity-oriented schemes of mutual funds, if the money can be invested for more than 10 years, as the returns on equity-oriented funds have been generally good and far better than the rate of interest on home loans of long tenures. This makes sense, considering that home loan tenures are generally more than 10 years. You need to compare the post-tax rates/returns in both the cases, to arrive at comparable numbers.
Many people prefer to not have any debt on their place of residence and this psychological reason contributes to a significant number of home loan prepayment cases in India.
How to prepay the home loan
In case you wish to prepay the home loan before its original tenure, you have two options. You can start a systematic investment plan (SIP) in equity funds, with the surplus money that you are able to save and increase the amount of SIP, as and when the income rises. When the value of your investments in such SIPs reaches the amount of the loan outstanding, you can redeem the investments in equity funds, after taking into account the exit load and tax implications and foreclose the home loan.
The second option is for the people who do not have much of patience. They can use the surplus fund that is not immediately required, to prepay the home loan, as and when available and your home loan will be paid up, before its original tenure. However, the first option is better, as the returns generated by the investments in equity funds in the longer run, will be better than the interest you pay on your home loan.
(The author is a taxation and home finance expert, with 35 years’ experience)