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A good way to deal with higher interest expenses is to make a partial prepayment and reduce the total outstanding loan. However, prepaying the loan is not always a good proposition for many borrowers. On the one hand, the interest rate on the home loan is among the lowest (compared to other loans) and borrowers benefit from unique tax saving opportunities on principal and interest payments. However, this has its own limitations, and in many circumstances borrowers are better off partially prepaying their home loans. Here’s when prepayment will work for you.
When the annual interest payment exceeds Rs 2 lakh
The majority of home loan borrowers generally use up to Rs 2 lakh deduction under Section 24b of the Income Tax Act 1961 on the home loan interest payment on a detached house. In the case of people falling in the 20% or 30% tax brackets, this deduction ends up giving an annual tax saving of Rs 40,000 and Rs 60,000 respectively. So even if they have excess money, they may choose to invest rather than prepay their loans, as this would reduce their outstanding loan, hence the interest and tax benefits as well.
However, a hike in rates can upset the balance as they will end up paying more interest than Rs 2 lakh which will be wasted as it will not give any tax benefit. For example, on a loan of Rs 30 lakh at an annual interest rate of 6.75%, the total interest expense over a year is Rs 2 lakh, however, if the rate increases by 1%, then the total interest expense will increase to Rs 2.3 million. Thus, the additional payment of Rs 30,000 due to interest increases the cost of the home loan without any tax benefit. Here, if you make a partial prepayment such that the annual interest expense reaches almost Rs 2 lakh, it would be an effective use of home loan.
“Existing home borrowers can use surpluses stored in low yielding fixed income products to make prepayments of home loans. Interest rates charged on home loans are generally higher than the interest rates offered on the most fixed income products,” says Ratan Chaudhary – Head of Home Loans, Paisabazaar.com.
In the example above, a partial prepayment of Rs 4 lakh will reduce the total interest expense in one year to around Rs 2 lakh, allowing the borrower to utilize all of the interest expense to save tax. In case of higher outstanding loans, borrowers should opt for higher partial prepayments or make frequent partial prepayments to bring the outstanding amount down to a level where the annual interest spent is around Rs 2 lakh.
However, if you are confident that you will generate a return on excess that exceeds the increased cost of your home loan, you may not need to use the partial prepayment option. “It makes sense to keep a home loan that gives a tax refund only if your savings or (after-tax) return on investment is greater than the after-tax return of the home loan. This can happen if you do the calculation of the spreadsheet and see the interest earned versus interest paid after tax,” says Malcolm Athaide, CEO and co-founder of Agrim Housing Finance.
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When the 80 C deduction is not fully utilized
Although you can get a full deduction on the interest payment if it is less than Rs 2 lakh, there are many situations where the annual principal repayment remains well below Rs 1.5 lakh. For example, on a loan of Rs 25 lakh at an interest rate of 7.5% for a term of 20 years, the annual principal repayment is Rs 56,080. Any prepayment made beyond the monthly amount of the EMI is considered a repayment of principal and therefore will be eligible for the Section 80C deduction.
In the example above, you can get a deduction of 80C on Rs 56,080 for principal repayment of a home loan, however, the deduction of Rs 93,920 on 80C will remain unused if you have no other expenses or qualifying investment under Section 80C.
However, if you have other 80C avenues like EPF, PPF, life insurance policies and tuition payment of around Rs 50,000, you can make partial prepayment of Rs 43,920 to use the benefit full of Rs 1.5 lakh deduction under Section 80C.
In another scenario, if you have no other way to utilize the Section 80C annual deduction limit of Rs 1.5 lakh, making a higher partial prepayment will help you increase this deduction. So, if you make a partial prepayment of Rs 93,920 lakh, you can use the full benefit of Rs 1.5 lakh from the Section 80C deduction.
When no tax advantage is needed for affordable home loans
With a standard deduction of Rs 50,000, a Section 80C deduction of Rs 1.5 lakh and other tax benefits like LTA and medical insurance, many people with an annual taxable income of around Rs 7 -8 lakh will end up paying no 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 don’t need a home loan to save tax. “In an ideal world for the affordable housing segment, if the client does not receive tax breaks, any low interest investment would have to be liquidated to prepay or partially pay off the home loan,” says Athaide. Rising interest rates give you a more compelling reason to consider partial prepayments.
However, if the low-yielding excess fund is for your emergency needs, you shouldn’t touch that money. “Existing borrowers should not sacrifice their fixed income investments for emergency funds or unavoidable financial goals. This could force them to resort to loans at much higher rates to meet financial demands or to meet their inevitable financial goals,” Chaudhary said.