According to Maslow’s hierarchy of needs “Safety Needs such as Personal security and a shelter to stay” is one of the basic needs of every human being. More than a basic need, we all aspire to buy our “dream home” come what may.
Purchasing a house often needs detailed planning of your finances as it has a huge impact on your existing and future financial situation. Property prices are always on the rise, and often it becomes difficult to pay the entire cost of purchase from your savings. Most opt for a home loan for two reasons – they couldn’t afford to pay the entire amount up front, or they take a loan for the tax benefits.
Home loan offers certain tax benefits as well. Interest paid towards home loan can be claimed as a deduction under Sec24 of the IT Act up to a limit of Rs. 2 lakhs p.a. and the amount paid towards principal in each financial year can be claimed under Sec80C up to a limit of Rs. 1.5 Lakhs p.a. Any loss on income from house property can also be carried forward up to 8 financial years.
THINGS TO LOOK FOR IN A HOME LOAN
Most banks offer attractive home loan interest rates, enticing home buyers to choose a home loan. From a financial planning perspective, one must always evaluate a home loan with the following criteria in mind
- Rate of interest – Look for the best rate of interest in the market available for you. This may vary from bank to bank, and also depends on your creditworthiness. Maintaining a good credit score will help you to negotiate a better rate of interest from the lender.
- Tenure – the loan term decides how long you must continue paying the EMI to make the home yours. Longer the loan tenure, the smaller the EMI for the same interest rate. There are other advantages to choosing a longer tenure – you pay lower EMI which will result in excess monthly cash flow which can be utilized towards saving for your other financial goals.
- EMI – This is linked to the tenure you choose, and your current cashflows. Banks will only lend you money, depending on your repayment capacity. They will assess your financial capacity to decide whether you will be able to service the EMIs or not. So, evaluate your existing financial obligations such as saving towards your other financial goals, meeting your everyday requirements, etc before choosing a higher EMI.
STRATEGY TO PRE-PAY YOUR HOME LOAN
Typically, home buyers plan to pre-close their home loan before the loan tenure. Though the idea of being debt-free can be enticing, it is important that you understand both the pros and cons of closing the home loan earlier.
One strategy you can follow while going for home loan pre-payment is “Dynamic Management of Debt”. The concept mainly is to allocate your funds towards an instrument which is more beneficial to you – financially. At any given time, you should evaluate the current interest rate environment and investment environment before pre-paying the outstanding principal. In those situations where the spread is positive (i.e.) Investment Return > Interest rate, it makes sense to redirect your money towards investments rather than locking the money by prepaying the principal.
One must understand the time value of money concept – money in hand today is worth more than the one tomorrow. Because money at hand can be parked in better return-yielding assets and be more tomorrow. The same principle must be applied while pre-paying home loans. When the investment avenues are attractive, redirect the money towards investments and let it grow. When the situation turns and interest rates are on the rise, you may redirect a portion of your investments towards bringing down the home loan principal.
There is no thumb rule for loan pre-closure, following a dynamic strategy will be beneficial to your finances. Though it might seem counterintuitive, it is better to continue with your home loan a little longer and invest any surplus towards building an investment portfolio during times when there are attractive investment opportunities. The tax benefit that you receive from your home loan is the icing on the cake!
Let’s take an example – Arvind has taken a home loan for Rs. 1 Crores at a rate of 7.5% for 20 years. EMI in this case comes to Rs. 80,560. Let’s assume he gets an annual bonus of 5 Lakh p.a. post-tax. Let’s take the current trend of investment rates to be 11% p.a. If he redirects the bonus towards loan closure, he must be able to close the loan in 10 years. But, if he redirects the bonus towards investments, the accumulated value at the end of 10 years will be approximately 83 Lakhs. The home loan principal outstanding by the end of 10 years is ~Rs. 67.86 Lakhs. At the end of 10 years, he may decide to close the outstanding principal amount from his investment corpus, and still be left with ~Rs. 15.75 Lakhs at hand.
The verdict – always follow a dynamic strategy when it comes to loan pre-closure.
In the above example, we had considered interest rate and investment rate to be constant, but it is not so in real life. Thus, frequent monitoring of your home loan and investment portfolio is crucial to benefit from this strategy.