You need to pay your daughter’s college fee of Rs 15 lacs in the coming month. You are wary of visiting the bank branch multiple times for getting an education loan sanctioned. You took a home loan 5 years back. You get a call from your bank that you are eligible for a top-up home loan for up to Rs 20 lacs. Fortunate timing. Your relationship manager also promises a low rate of interest and swift paperwork. You like the deal, but going by a recent statement by the RBI Governor, the central bank has a few reservations about top-up home loans.
What Is a Top-up Home Loan?
Let’s understand this with the example of a home loan.
The value of your house is Rs 75 lacs. Your home loan outstanding is Rs 35 lacs. Your equity (ownership) in the house is 75-35 = Rs 40 lacs.
The bank has no problems lending up to 80% of the value of your house. That means the bank can lend up to Rs 75 lacs X 80% = Rs 60 lacs for your house.
Hence, it may be willing to offer you a top-up loan of up to 25 lacs (60 lacs – Rs 35 lacs) against your house. This top-up loan is over and above your housing loan.
Since this top-up loan is against your equity in the house, these loans are also called home-equity loans.
You must ideally use top-up loans to add to your house — Repair, construction, and renovation.
What Are the Benefits of a Top-up Home Loan?
- Hassle-free (the bank already knows about your repayment history)
- Minimal documentation
- Cheaper than a personal loan
- Longer tenure than a personal loan. You will find it difficult to get a personal loan for more than 3-5 years. However, the banks usually have no problems in making the top-up loan co-terminus with your base home loan. Longer tenure means a lower EMI.
- You also get tax benefits for repayment of top-up home loan provided you have used the proceeds for repair, construction, or reconstruction of the house. You get tax benefit of up to Rs 30,000 per annum for interest payment under Section 24 of the Income Tax Act.
- This benefit is available only if you file your Income tax returns under the old tax regime.
- The total benefit for interest payment for base home loan and top-up home loan under Section 24 is capped at Rs 2 lacs
Why Is RBI Worried about Top-up Loan?
I reproduce an excerpt from RBI Governor’s statement on August 8, 2024.
RBI is concerned that such top-up loans have grown at a brisk pace and certain lenders are not tracking the end use.
As I understand, RBI has not put any restrictions on how the proceeds from top-up home loans must be used. At least I could not find a circular putting such restrictions. However, the central bank is concerned if top-up home loans are being used for unproductive or speculative purposes.
The loan agreements have clauses that prohibit borrowers for using loan proceeds for indulging in speculation (say futures and options). However, if the lenders are not tracking the end use, as the RBI Governor has pointed out, then borrowers may not comply with this restriction.
The banks have also not held back. Here is a display from ICICI Bank website.
As you can see, while RBI may not have put restrictions, the lender is encouraging borrowers to take top-up loans for anything under the sun. And if you don’t track the end use, the borrowers will indeed use top-up loans for anything.
The banks are happy doling out such loans because:
- The loan is secured.
- The banks have comfort with the borrower and his/her repayment ability. In any case, no one wants to default on a loan secured by their house.
- Lower risk weights. Hence, the cost of the loan can be low.
- The quantum of loan can be big.
Earlier, in November 2023, the Reserve Bank had increased the risk-weightage for top-up loans against movable and depreciating assets (such as vehicle loans) from 100% to 125% by considering such loans as unsecured loans. However, the risk weights for other secured top-up loans such as home loans and gold loans were left untouched. We had written about the November 2023 circular and how risk weights affects lending in certain segments. RBI has not increased risk-weight for top-up home loans to discourage lenders but has simply asked the banks to be cautious.
As a Borrower, You Must Be Responsible
Credit gives you power to spend money that you have not yet earned. Hence, you must be responsible while taking credit. While I must not stand in judgement about how you must spend the loan proceeds, you must utilize the proceeds responsibly.