To raise loan tenure or EMI?

Figure out the better bet in the event of a rate rise, considering the tax benefits

A rise in the home loan interest rate is a cause of worry for borrowers. But many may not even realise it until they read the letter from their lender carefully. Typically, if age is on your side, the tenure is increased. If not, the equated monthly instalment (EMI) is raised.

“An EMI rise is a not a preferred option because it increases the financial pressure on the borrower. This can lead to increased defaults. No wonder banks prefer to keep the customer’s EMI constant, so that he/she does not feel the pinch,” says a bank official. But here’s the catch. A rise in tenure may provide immediate relief, as the EMI does not go up but the interest payout to the lender rises.

Let’s take the example of 38-year-old Ajay Pawar, who borrowed Rs 23 lakh for 20 years at 8.5 per cent five years ago. His EMI was Rs 19,960. Five years later and after multiple rate adjustments, he was sitting on a 20-year-loan. And, his EMI had increased to Rs 23,585.

This October, his rate was increased from 11 per cent to 11.75 per cent. It meant that another 21 months were added to his tenure, while keeping his EMI the same. In other words, Pawar is currently sitting on an almost 22-year loan.

“And, this may not be the last rate hike. So, I am looking at making part payments in addition to my monthly EMIs,” adds Pawar.

In addition, the first five years’ payments were mostly the interest cost. Even if one keeps the interest rate the same (for the first five years) at 8.5 per cent, Pawar paid a whopping Rs 9.24 lakh as interest cost.

The saving grace: In the last five years, he was able to claim Rs 1.5 lakh a year as tax benefit under Section 24. It implied while he paid Rs 9.24 lakh as interest cost, he saved Rs 7.5 lakh on taxes. He paid Rs 1.74 lakh more without any tax benefits.

Another tax benefit available to him was for the principal payment of Rs 1 lakh under Section 80C. But since he only made principal payments of Rs 2.35 lakh in five years, he was unable to take the advantage completely. Anyway, a large part of the 80C amount was consumed by the Employee Provident Fund.

Longer tenure loans may let you pay constant EMIs. But the interest cost hurts badly. Avoiding these is what financial consultants advise clients such as Pawar.

“When tenures go up, the interest rate cost becomes difficult to bear. One’s ability to take this risk gets lower as retirement approaches, so repay as much possible while you can,” says Sandeep Shanbhag, a financial advisor.

If Pawar makes part-payments towards the bank each month, it will result in lower EMIs that are calculated on the balance principal outstanding every month. Home loan borrowers can prepay up to 25 per cent of their outstanding annually, without any penalty charges in most of the leading banks and housing finance companies. In case of pre-closures, however, most banks do not allow any prepayments to be made in the preceding 12 months.

In the reverse case, say Pawar’s rate had increased after the first year. And, instead of a tenure rise, he had opted for an EMI hike, things would have been different.

Say if the rate had increased by 100 basis points, from 8.5 per cent to 9.5 per cent. His outstanding principal would have been Rs 22,50,232 at the start of the second year. His EMI would have been Rs 21,351 – a rise of only Rs 1,391.

In the next four years, if he had opted for similar EMI hikes, he would have been left with around Rs 20 lakh of outstanding principal payment after completing five years at the existing rate of 11 per cent. When the rate is being raised to 11.75 per cent, his new EMI would be Rs 23,683. His EMI, in the last five years, has increased by Rs 3,723.

Of course, rate hikes normally take place by 25-50 basis points on a quarterly or half-yearly basis, depending on the market situation. Similarly, there are rate drops as well. However, a borrower needs to do the numbers properly, including the tax benefits. The best solution always is to opt for a rise in EMI, if you can afford it.