Owning a property is, perhaps, one of the most important goals of any salaried person.
However, buying one has become more difficult in the last few years.
With the Reserve Bank of India changing the loan-to-value ratio from to 80 per cent, buyers have to cough up at least 20 per cent of the property price. In addition, the apex bank has also said that banks should not include registration and stamp duty fees in the loan-to-value, thereby increasing the demand for cash substantially. And then, there is the loan repayment aspect as well which one has to provide for a number of years.
No wonder, there are times that one just wants to repay the entire loan at one go. For one, there is a sense of relief that there is no debt. Two, there is a freeing up of cash that one can use to invest or for other purposes.
But there is another aspect of it. There is a tax advantage that one gets – Rs one lakh of principal payment under Section 80C and Rs 1.5 lakh under Section 24. So it is a key call when to repay and exit the home loan. If you are considering prepaying, here’s what to consider before taking a decision.
STABILITY OF INCOME
Firstly, consider stability of income of the loan taker, say you. If that is questionable, servicing an equated monthly instalment (EMI) over the years to come can pose serious problems. The self-employed such as entrepreneurs and other professionals can find the income varying a great deal – surging at some points and dwindling at other times For such people, it makes sense to keep a lower income to EMI ratio (see next sub-head) because the loan repayment should not burden them during tough times.
Then, there are ones with erratic incomes such as sportspersons or film actors who can have purple patches in their career which is soon followed by long periods of lack of success. The second category, preferably, should make the best of the good times and make the big purchase and payment at the earliest.
Even for the employed, some jobs are more stable than others. In such situations, every endeavor should be made to reduce the loan amount, at every possible point, irrespective of the tax savings and other considerations. Bonus/ exgratia or any other inflow can be used to retire outstanding loans. This will bring down the exposure.
Point number two would be loan can be reduced also when the home loan EMI as a percentage of take-home salary is beyond 40 per cent. When the amount is higher than this, it exerts a lot of pressure on one's cash flows, which is not healthy.
Bringing the EMI amount to 40 per cent of the take-home income or less is desirable. It is even more necessary if there are other EMIs for vehicle loans or personal loans to consider. If the EMI goes below the 40 per cent threshold and does not pose cash flow problems, it can be continued, subject to effectively low interest rates.
People such as entrepreneurs or professionals who have uncertain cash flows should try and keep the EMI:income ratio to below 40, preferably 30 or 20, because it will not pressure them during tough times.
INTEREST RATE WOES
Thirdly, consider the effective rate of interest that you are paying. In case of home loans, the deductions for repaying the principal portion falls under Section 80C and deductions for the interest portion falls under Section 24.
After accounting for all the benefits, calculate the cost of loan. If the interest cost is above what you can earn from investments in a fixed income instrument, then prepaying the loan is desirable. For instance, if the net interest cost amounts to 9.75 per cent and the post-tax returns from any fixed income instrument is at best only 8.20 per cent, then it is preferable to prepay any extra amount one has.
On the other hand, if the rate of interest is below the earnings on investment, prepaying is better so that the cash is deployed better. However, remember that interest rates are cycles that will go up and down.
Next, consider is the loan tenure. If due to the increase in interest rate, the tenure extends beyond the superannuation age, consider it a red signal. It is desirable to bring the tenure down so that you can pay-off the loans before retirement. It would be safer.
Home loan is a comparatively low-cost loan. If one wants to access loans for other purposes, say for a vehicle, it may make sense to instead not prepay the home loan and use the cash to reduce the vehicle loan. This will reduce the overall costs.
Say you want to buy a Rs 4.5 lakh car in 2 years from now, and you also have a home loan of Rs 25 lakh at a rate of 9.75 per cent. It may be a good idea to not prepay the home loan in the next two years. Instead invest the amount that could have been used for prepayment to reduce the vehicle loan to be taken at a later date. Vehicle loans would charge anywhere between 2 and 4 per cent more than a home loan and they offer no tax breaks for salaried.
After these considerations, you could decide whether to keep the home loan or part-pay it. You could also tweak the EMI. That is, you could keep the EMI high, in spite of the prepayment, to bring down the loan tenure. Or, you could allow the EMI to come down as the loan exposure amount goes down, if a long tenure does not pose a problem for you.
The main aspect to keep in mind is that do not get obsessed with closing the home loan at the earliest. Consider properly before taking a final decision lest you repent later.
The writer is a certified financial planner