Source: The Economic Times
If you have an outstanding home loan, and happen to have
just received an annual bonus or any other lump sum payment, should you use it
to prepay your loan? Or, should you invest it to meet some other goals? Assess
the following conditions to arrive at the right decision.
The first variable
to be considered is psyche: some people may not be comfortable with a large
housing loan and to reduce their stress they may want to get rid of the loan
burden at the earliest. For them, settling the question of how to use their
bonus is simple: just pay off the loan. Gaurav Mashruwala, Sebi-registered investment
adviser, categorically states: "You
should pay off the home loan at the earliest. Several unfortunate happenings—
job loss, death of the earning member, serious illness, etc—can cause trouble
during the 10-15 year loan period. Treat it as a mind game and not a numbers
game."
Tax benefit is the
next variable. If a home loan does
not seem like the sword of Damocles hanging over your head, it makes sense to
continue with the regular EMI schedule. This is because of the tax benefits
that a home loan offers. The principal component of the EMI is treated as
investment under Section 80C. The interest component is also deducted from your
taxable income under Section 24. The annual deduction in respect of the
interest component of a housing loan, for a self occupied house, is limited to
Rs 2 lakh per annum.
You won't be able to claim deduction on interest paid
above Rs 2 lakh. So, if your annual interest outgo is higher than Rs 2 lakh, it
makes sense to prepay the loan, and save on future interest payment. For
example, the annual interest on a Rs 70 lakh outstanding loan, at 9.5%, comes
out to be Rs 6.65 lakh. After taking into account the Rs 2 lakh deduction under
Section 24C, the interest component will fall to Rs 4.65 lakh, and bring down
the effective cost of interest from 9.5% to 8.64%, even for the people in the
30% tax bracket.
You can, however, optimise the tax benefits if the loan
has been taken jointly, say, with your spouse. "If joint holders share the
EMIs, both can claim Rs 2 lakh each in interest deduction," says Harsh
Roongta, Sebi-registered investment adviser. In case of joint holders, there is
no need to prepay if the outstanding amount is less than Rs 40 lakh.
There is no cap on deduction in lieu of interest paid on
home loan, if the property is not self-occupied. "Since there is no cap
for interest on loan against second or rented out homes, there is no need to
prepay it," says Naveen Kukreja, CEO and Co-founder, Paisa Bazaar. Bear in
mind, by prepaying your loan, you may also forego future tax benefits. For
instance, if by prepayment, you bring
down your outstanding loan amount to Rs 20 lakh, your annual interest outgo for
subsequent years may fall below Rs 2 lakh. Thus, you won't be able to avail of
the entire tax-deductible limit and, in such a scenario; prepayment may not be
a good strategy. Also, building an emergency fund, if you don't have one,
should take a priority over prepaying the housing loan: "Make sure that
you have a contingency fund in place before opt for prepaying your home
loan," says Roongta.
The third key
variable is returns from investment of the lump sum at hand. As a thumb
rule, you should go for investment, instead of prepayment, only when the post-tax
return from the investment is likely to be higher than the effective cost of
the housing loan. For investors in the
30% tax bracket, and whose outstanding home loan balance is less than Rs 20
lakh, the effective cost of loan is only 6.65%. Since there are several
risk-free, tax-free debt options such as PPF, Sukanya Samruddhi Yojana and
listed tax-free bonds , which offer higher annualised return than this, it
makes sense to invest in them.
All the debt products mentioned above are long-duration
products. If your risk taking ability is higher and time horizon is longer, you
can consider investing in equities , which can generate better returns "It's
sensible for long-term investors (five year-plus holding period) to go for
equities, provided they are savvy and understand the risks involved
there," says Kukreja.
There are some
home loan products that provide an overdraft facility of sorts and help you
maintain liquidity. All you have to do is to park the surplus money in these
products and not bother with whether it's a prepayment or not. It's like prepayment
with the option of taking out that money, in case you need it in future for
personal use or for investment purpose.
The strategy of maintaining the housing loan interest close to Rs 2 lakh per
annum can also be managed by these special loan products. And even if you
are going to invest, the SIPs can go from this account.
"I park my bonus and do SIPs in equity from the loan
account," says Kukreja. Most banks charge more for these special loan
products. "Though the stack rate differential is more, you can bring it
down by bargaining with the banks," he adds.
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