You have 2 home loans. You got an annual bonus. You want to prepay your home loan. Which home loan would you prepay first? Clearly, the one with a higher rate of interest, right? You save more by paying off the loan with a higher rate of interest.
Ready-to-Move-in or under-Construction Property?
The choice will also depend on whether the property is ready-to-move-in or is under construction. Why?
For an under-construction property, you do not get tax benefit for principal repayment under Section 80C or interest payment under Section 24. Thus, in absence of tax benefits, the post-tax cost of a home loan is the same as the loan interest rate.
The tax benefits for principal repayment and interest payment start only once you get the possession (or construction is completed). As the construction gets completed, the tax benefits kick in which reduces the effective cost of the home loan. And it is the effective (post-tax) cost of loan that matters for comparison.
Hence, it is possible that the home loan with a higher loan interest rate may have a lower post-tax cost if the house construction is complete (as compared to a home loan for an under-construction property at a lower rate of interest).
A loan at 8.5% (with tax benefits) may have a net cost of say 7% p.a. And a loan at 8% with no tax benefit costs 8% post-tax. In this case, it may make sense to pay off the loan at 8% p.a.
As a borrower, you must consider this aspect.
Yes, there are provisions under Section 24 where you can take tax benefit for the interest paid during the construction period once you get the possession. But let’s ignore those calculations for now.
You Do Not Have to Optimize Everything
Home loans are floating rate loans. Linked to a benchmark and the spread depends on your creditworthiness and the loan amount.
Hence, the interest rate on two home loans is not likely to be much different. If the difference is wide, you might want to check with your bank about the reason. Most likely, you will be able to reduce the interest rate gap.
Hence, the above exercise may indeed be moot. Just repay whichever loan you want. However, the point about completed and under-construction property still holds.
You can also ignore this complex math. I tend to complicate things unnecessarily. You don’t have to. It may be psychologically comforting to attack the smaller loan amount first.
Two home loans. The first home loan has Rs 40 lacs outstanding and the second home loan has only 15 lacs outstanding. You may want to close the Rs 15 lacs loan first even if the interest rate of this loan may be slightly higher than the first loan of Rs 40 lacs.
Why? For two reasons.
Firstly, the difference between the interest rates of two loans is unlikely to be much.
Secondly, it is comforting to have a lesser number of loans. 1 instead of 2. We discussed the two debt repayment techniques in an earlier post. Debt Snowball (repay smallest loan first) and Debt Avalanche (repay costliest loan first). The context in that post was quite different but still quite relevant. You may want to reduce the number of loans as it gives you greater psychological comfort.
Again, different borrowers may approach the same situation differently.
A few years ago, I would have gone for the most optimal solution. Repay the loan with the highest post-tax cost. However, over the years, I have grown to appreciate that there are no black and white answers. Not all decisions have to be rational. There are emotions involved. And you cannot price in emotional comfort and peace of mind in Microsoft Excel.
What would you do?