You have excess cash in hand from the last bonus you received and the fixed deposit that just matured. You have been thinking about how to use the funds. Your financial advisors that include your friends, doctor, lawyer and grocer have suggested that you take exposure to equity mutual funds. Your parents have advised you to purchase another house.
Wait. Your loan for the first house is not yet over. Should you use the funds to part-prepay your home loan? But you think you might lose out on some of the tax benefits that home loan repayment offers you. Many in your position will want to continue with the home loan because it gives you tax benefits. However, in my opinion, you do not get as much tax benefit as you think you do.
Tax Benefits on Home Loan Repayment
Principal repayment is eligible for tax deduction up to Rs 1.5 lacs under Section 80C of the Income Tax Act. Interest payment on housing loan is eligible for tax deduction for up to Rs 2 lacs for a self occupied house. In case the house is let out or deemed to be let out, entire interest paid towards housing loan is eligible for tax deduction. For more on tax benefits on housing loans, you can go through this post.
For loans sanctioned in FY2016-17, the tax deduction for interest payment could be higher, but for the majority, Rs 2 lacs deduction is the limit.
In Some Cases, Tax Benefits on Housing Loans Are Overhyped
There is no denying that the repayment of housing loan comes with tax benefits. However, don’t build it up in your head. It is not as if the loan becomes free of cost just because you are availing tax benefits. Tax benefits reduce the home loan cost only to an extent.
Let’s make an objective assessment. Let’s look at repayment schedules of two home loans
- Rs 20 lacs , 10% p.a., 20 years
- Rs 50 lacs, 10% p.a., 20 years
The two schedules show yearly principal repayment and interest payment during the entire loan tenor.
| Loan Amount | 5,000,000 | |||
| Interest Rate | 10% | |||
| Tenor | 20 | |||
| EMI | 48,251 | |||
| Year | Principal Repayment | Interest Payment | Maximum Tax Benefit for Principal Repayment | Maximum Tax Benefit for Interest Payment (Self-Occupied House) |
| 1 | 82,737 | 496,276 | 82,737 | 200,000 |
| 2 | 91,401 | 487,612 | 91,401 | 200,000 |
| 3 | 100,971 | 478,042 | 100,971 | 200,000 |
| 4 | 111,544 | 467,469 | 111,544 | 200,000 |
| 5 | 123,225 | 455,788 | 123,225 | 200,000 |
| 6 | 136,128 | 442,885 | 136,128 | 200,000 |
| 7 | 150,382 | 428,631 | 150,000 | 200,000 |
| 8 | 166,129 | 412,884 | 150,000 | 200,000 |
| 9 | 183,525 | 395,488 | 150,000 | 200,000 |
| 10 | 202,742 | 376,270 | 150,000 | 200,000 |
| 11 | 223,972 | 355,041 | 150,000 | 200,000 |
| 12 | 247,425 | 331,588 | 150,000 | 200,000 |
| 13 | 273,334 | 305,679 | 150,000 | 200,000 |
| 14 | 301,955 | 277,058 | 150,000 | 200,000 |
| 15 | 333,574 | 245,439 | 150,000 | 200,000 |
| 16 | 368,504 | 210,509 | 150,000 | 200,000 |
| 17 | 407,091 | 171,922 | 150,000 | 171,922 |
| 18 | 449,718 | 129,295 | 150,000 | 129,295 |
| 19 | 496,810 | 82,203 | 150,000 | 82,203 |
| 20 | 548,832 | 30,181 | 150,000 | 30,181 |
| Loan Amount | 2,000,000 | |||
| Interest Rate | 10% | |||
| Tenor | 20 | |||
| EMI | 19,300 | |||
| Year | Principal Repayment | Interest Payment | Maximum Tax Benefit for Principal Repayment | Maximum Tax Benefit for Interest Payment (Self-Occupied House) |
| 1 | 33,095 | 198,510 | 33,095 | 198,510 |
| 2 | 36,560 | 195,045 | 36,560 | 195,045 |
| 3 | 40,389 | 191,217 | 40,389 | 191,217 |
| 4 | 44,618 | 186,987 | 44,618 | 186,987 |
| 5 | 49,290 | 182,315 | 49,290 | 182,315 |
| 6 | 54,451 | 177,154 | 54,451 | 177,154 |
| 7 | 60,153 | 171,452 | 60,153 | 171,452 |
| 8 | 66,452 | 165,154 | 66,452 | 165,154 |
| 9 | 73,410 | 158,195 | 73,410 | 158,195 |
| 10 | 81,097 | 150,508 | 81,097 | 150,508 |
| 11 | 89,589 | 142,016 | 89,589 | 142,016 |
| 12 | 98,970 | 132,635 | 98,970 | 132,635 |
| 13 | 109,333 | 122,272 | 109,333 | 122,272 |
| 14 | 120,782 | 110,823 | 120,782 | 110,823 |
| 15 | 133,430 | 98,176 | 133,430 | 98,176 |
| 16 | 147,401 | 84,204 | 147,401 | 84,204 |
| 17 | 162,836 | 68,769 | 150,000 | 68,769 |
| 18 | 179,887 | 51,718 | 150,000 | 51,718 |
| 19 | 198,724 | 32,881 | 150,000 | 32,881 |
| 20 | 219,533 | 12,072 | 150,000 | 12,072 |
You can observe from both repayment schedules that you pay more interest during the initial years and more principal during the later years of loan tenor.
So, what’s the problem? Let’s consider some of the reasons why tax benefits on home loans are over-hyped.
1. Tax Benefits Are Capped for Principal Repayment under Section 80C
Tax benefit for housing loan principal repayment under Section 80C is not exclusive. Many other investments and expenses such as EPF and PPF contributions, life insurance premium, children’s tuition fees etc. provide the same tax benefit under Section 80C. Hence, for many of us, Section 80C limit of Rs 1.5 lacs is already exhausted even before principal repayment comes into picture. So even though you are paying a significant amount towards principal repayment every year, you may not get much benefit out of it.
Suppose you are contributing Rs 80,000 from your salary to EPF. You invest Rs 50,000 in PPF every year and pay insurance premium of Rs 30,000 annually. These three expenses/investments add up to Rs 1.6 lacs per annum. So, you have already exhausted your Section 80C limit. It does not matter if you are paying Rs 1.23 lacs (6th year, Rs 50 lac loan) towards principal repayment. You won’t get any tax benefit for such repayment as Section 80C limit is already exhausted.
Or you may not be able to get the full benefit. For instance, you were only spending Rs 1 lac towards EPF, PPF and life insurance premium (and any other 80C product); you will be able to get tax benefit only to the extent of Rs 50,000. This is despite the fact that you are repaying Rs 1.23 lacs of principal during the year.
The extent of tax benefit (actually received for principal repayment) will vary from person to person. It is quite possible that you may get the tax benefit for the entire principal repayment. However, you need to consider your investments to see if you are really getting any tax benefit for principal repayment. If you find out that you are not getting much benefit for principal repayment, then probably your resistance to prepayment of loan will go down.
However, you get tax benefits not just for principal repayment, but for interest payment too. What about interest? You are right. Let’s look at the next point.
2. You May Not Even Get Tax Benefit for Entire Interest Payment
Benefit for Interest payment is exclusive, but the benefit for self-occupied property under Section 24 is capped at Rs 2 lacs per financial year.
You can see interest payment for high value loans (Rs 50 lacs) is much higher than Rs 2 lac limit during the initial years. For instance, in the first year, you are paying interest of Rs 4.96 lacs. You won’t get any tax benefit for the amount in excess of Rs 2 lacs. In case of low value loans, you can use this limit to the hilt. For instance, in case of Rs 20 lac loan, you can get benefit for the entire interest paid. If the outstanding principal amount is quite high, you may not get tax benefit for the entire interest amount paid.
What does this tell you? It tells you that you may not be getting as much tax benefit from your home loan as you are thinking. You may have decided not to repay the loan because of tax benefits. But are you getting as much tax benefits as you think you are? Your decision will depend on multiple factors such as outstanding principal amount, interest rate and remaining tenor. You can work out the numbers and find the tax savings for yourself. If you are taking full tax benefits of your home loan, the effective cost of loan may not be as low as you are thinking.
3. Lower Income Tax Slab Means Higher Post-Tax Cost of Loan
The exact tax savings will depend on your income tax slab too. So, if you get tax benefit of Rs 2 lacs on interest payment, it does not mean your tax saving is Rs 2 lacs. Essentially, your total income will go down by Rs 2 lacs. So, tax-saving will be Rs 61,800 (Rs 2 lacs * 30.9%) if you are in 30% tax bracket. The actual saving will be Rs 41,200 and Rs 20,600 if you are in 20% and 10% tax bracket respectively. It goes without saying that the buyer in the highest tax bracket gets the maximum tax benefit.
What Is the Effective Cost of My Loan?
Many people will reply, Interest Rate * (1- Marginal Income Tax Rate). So, if interest rate on home loan is 10% p.a. and you are in 30% tax bracket, effective cost of your loan is 7% p.a. If you are in 20% tax bracket, then the effective cost is 8% p.a. Really? Let’s find out.
I will continue with the two loans discussed above.
| Income Tax Slab | Effective Cost | |
| Rs 20 lacs | Rs 50 lacs | |
| 10% | 8.97% | 9.50% |
| 20% | 7.95% | 8.99% |
| 30% | 6.92% | 8.48% |
I have not considered any tax benefit for principal repayment because the benefit is not exclusive. Your section 80C limit may get exhausted even before principal repayment comes into picture. However, if in your case, you are actually managing income tax benefit from principal repayment, the effective cost of loan will go down even further.
You can see the effective (post-tax) cost of loan is not as low as you were thinking. This is because tax benefits are capped. Another point to note is that the effective cost of loan will keep changing during the tenor of the loan. For instance, if we move 10 years further i.e. you have repaid loan for 10 years, the effective cost of loan will look something like this.
| Income Tax Slab | Effective Cost | |
| Rs 20 lacs | Rs 50 lacs | |
| 10% | 8.98% | 9.26% |
| 20% | 7.96% | 8.52% |
| 30% | 6.95% | 7.77% |
You can see the post-tax cost of loan for Rs 50 lacs loan has gone down significantly. This is because the interest payout has gone down and you are utilizing tax benefits better. So, there is no crisp answer. It is dynamic. Open up a spreadsheet (or use Home Loan EMI Calculator) and work out the numbers for your case. In fact, it may make sense to prepay part loan so that you can utilize tax benefits better.
I Have a Let-Out Property. Entire Interest Paid Is Deductible.
This is interesting. For a let-out property, the entire interest payment is tax deductible. Hence, the effective cost of loan is actually Interest Rate * (1- Marginal Income Tax Rate). If you are 30% tax bracket, your post-tax cost of loan will be 6.91% (for loan at 10% p.a.). It can be even lower if you were making use of tax benefit for principal repayment under Section 80C. It is quite clear the post-tax cost of loan will be lower for a let-out property as compared to a self-occupied property. This is because you get tax benefit for entire interest paid.
4. Prepay or Invest
In the previous points, I have tried to find out effective cost of loan for self-occupied and let-out properties. But why do you need to find out effective cost of loan? For this, we need to go back to the original problem case. You have money in hand. Should you prepay your home loan or invest somewhere else?
Read: Which loan to prepay first?
Typically in such cases, if you can find an investment that gives better post-tax return than the cost of your loan, then you must invest or else prepay. An additional point to remember is that return on your investment may not be guaranteed but you cannot default on your loan payment.
Hence, in my opinion, the investment should have a comparable risk profile. In my opinion, a fixed deposit comes close. The returns are almost guaranteed. You invest in a fixed deposit which gives you 8% pre-tax. Since you are in 30% tax bracket, your post-tax return will come to 5.6% p.a. You are not prepaying a loan which costs you 6.9% p.a. (that too for a let-out property) and investing in product that gives you 5.6% p.a. Do you think this is the right approach?
You might argue that equity funds will give better returns than post-tax cost of loan over the long term. Hence, you must consider equity funds too. Nothing wrong. However, equity funds do not provide guaranteed returns (like a FD does). Personally, I wouldn’t consider equity funds. The idea is that you cannot compare apples and oranges. Home loan is a debt product. Compare it with a debt product only. If you always compared long term returns of FDs and equity funds, nobody will invest in fixed deposits. Debt and equity products serve different purposes in your portfolio and you must strike a balance.
Another alternative could be tax-free bonds (interest is exempt) or debt mutual funds (tax only on redemption). However, tax-free bonds issues are not always open and even if the issue is open, you may not get as much as you want. With debt funds, there is an element of market risk. I am not saying FD is strictly comparable but it comes quite close (at least in terms of investor discretion).
Read: How to reduce home loan interest burden?
So, you can see it is not easy to find comparable investments that can provide a higher guaranteed return than post-tax cost of loan.
5. Don’t Think of Your House as a Mere Investment
If you are repaying a loan for home loan that you bought for investment purposes (let-out property or your second house), draw up a spreadsheet and make the most rational and optimal financial decision. You may even choose higher risk-reward of equity funds instead of prepaying home loan.
However, if you purchased a house for your family to stay in, do not get too rational. Though it is not a good idea to involve emotions in your financial decisions, in this case, your emotions may actually show you the right direction. If something were to happen to you, your family should be able to get control of the house. You don’t want your family to be staring at a loan of Rs 60 lacs just to get hold of the house. You might say you have term insurance to take care of it. Good. However, does that take care of the loss of job or any disability that may hamper your ability to earn? Make that home loan amount manageable. You can do that by part pre-paying loan at regular intervals. You (and your family) need a house to stay in. Make sure you own it at the earliest.
Conclusion
I am not saying you must prepay the home loan whenever you have cash in hand. All I am saying is that you should not hold back only because you think you are getting heavy tax benefit on home loan repayment. That may not be true. Open up a spreadsheet and assess how much tax benefits you are really getting. The answer may surprise you. Compare the post-tax cost of loan with post-tax returns on investment opportunities you have before making the decision.
Moreover, do not get too rational if you are talking about your first house. Try to own it as early as possible i.e. try to repay its loan as early as possible. If you find full repayment beyond your means, at least try to make the loan amount manageable. You can take liberty if you are talking about your second house.
However, there is a caveat. Don’t get obsessed with home loan repayment. Repayment of home loan should be a high priority goal. But this does mean planning for other goals should be put on the backburner. Take a balanced approach.
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