You have some cash in hand because of the recent annual performance bonus that you received. You have not yet decided how to use that money. You have no credit card or personal loan which needs to be settled at a high priority. You only have a home loan but you are not planning to part prepay it because you will lose out on tax benefits.
This is a common refrain among home loan borrowers. They do not want to prepay their loan just because of associated tax benefits. I do not deny that home loan repayment comes with tax benefits bringing down the effective cost of loan.
However, sometimes, these tax benefits on home loans can be overrated.
Since the tax benefits are capped, you may not get as much tax benefit as you think you are. In fact, you may pay off part of the loan and still get almost similar tax benefits.
Tax Benefits of Home Loans
- Deduction in total income by up to Rs 1.5 lacs for principal repayment under Section 80C of the Income Tax Act
- Up to Rs 2 lacs for interest payment for a self-occupied property under Section 24 of the Income Tax Act. For a let-out or a deemed let-out property, there is no cap on tax benefit for interest payment.
Must Read: Tax Benefits on Home Loan Repayment
Let’s see why income tax benefits for home loan repayment are exaggerated.
You may get limited Tax Benefit for Principal Repayment
- You may be re-paying more than Rs 1.5 lacs of principal in a financial year. The tax benefit is capped at Rs 1.5 lacs per financial year.
- Even if you are paying less, your other Section 80C investments such as PPF, EPF, ELSS, insurance premium etc may exhaust the entire or major portion of Rs 1.5 lacs even before principal repayment comes into picture.
- You get tax benefit for principal repayment only once you get possession of the house. Principal repayment done before the financial year in which you got possession of the house does not get you any tax benefit. This assumes important for tax-payers who have purchased under-construction property.
You may get limited Tax Benefit for Interest Payment
The tax benefit for interest payment is capped at Rs 2 lacs per financial year for a self-occupied property. So, if you are paying more than Rs 2 lacs interest in a financial year, the excess interest paid won’t fetch you any tax benefits.
During the initial years of your home loan, a major chunk of your EMI goes towards interest payment while it goes towards principal repayment during the later years.
Therefore, if you have a high value loan, the interest payment in the initial years will be much larger than Rs 2 lacs.
I consider two loans of Rs 30 lacs and 60 lacs, interest rate of 10% and a loan tenor of 20 years.
For Rs 60 lacs loan, you are paying much more than Rs 2 lacs per annum in the initial years. In the first year, you have to shell out Rs 5.95 lacs towards interest payment. However, you get the tax benefit only to the tune of Rs 2 lacs.
Moreover, if you see, for the first 11 years of loan repayment, the benefit for interest payment of Rs 30 lacs loan is same as tax benefit for Rs 60 lacs loan i.e. Rs 2 lacs per annum.
Hence, even if you had prepaid Rs 30 lacs in Rs 60 lacs loan, the tax benefit for the interest payment wouldn’t have gone down by much.
I have not considered tax benefit for principal repayment as the tax benefit is not an exclusive. It is quite possible that your EPF/PPF contributions, ELSS investments or life insurance premium already amount to more than Rs 1.5 lacs. In such a case, you will not any tax benefit for principal repayment because the Section 80C limit is already over.
In your case, if you have planned your investments in a way that you are getting some benefit for principal repayment, you can work out these numbers for your loans and find out the impact of pre-payment on tax benefits.
It is quite possible that, with your loan particulars, you may get greater tax benefits. For instance, if your loan amount was only Rs 20 lacs, your interest payment for all the years will be less than Rs 2 lacs per annum. In such a case, you will lose out on tax benefit for interest payment in case of part-prepayment.
However, come to such conclusion only after you have done these calculations.
Hence, if you are holding yourself back from making the home loan pre-payment just because of tax benefits, think twice. You may not be getting as much tax benefit.
If you are facing issues in calculating numbers, you can go to EMICalculator to find out the annual principal and interest payment for your loan.
You need to make home loan amount manageable
In my opinion, not every decision should be a financial decision.
If the loan under consideration is for the house that you or your family plans to stay in for a long time, you should be reasonably aggressive in closing down the loan. This will apply to most first time home buyers.
You do not want to leave your family a loan of Rs 60 lacs to settle. You might argue that you have purchased a term life insurance which should be sufficient to settle the home loan amount. By the way, do you have enough life insurance?
However, there are other reasons which might affect your repayment ability such as a prolonged illness, loss of job, accidental disability or disability due to illness. For some of these events, you cannot even purchase any insurance. Even if you do (like personal accident cover or critical illness cover), the insured event is not so objective in these plans (as in life insurance). Insurance companies have a lot of discretion. You know what that means.
What will your family do if such an event were to happen?
In my opinion, if it is your first house, do not think too much about tax benefits. Prepay the loan aggressively to make it manageable. This will also provide financial security and emotional comfort to you family.
What is a manageable home loan amount? It depends. In my opinion, it should be an amount that your spouse can manage to repay on his/her own. If your spouse is non-working, it should be the amount of assets that you wouldn’t mind disposing off to repay the loan fully. Of course, such sale shouldn’t affect your other financial goals.
If your home loan amount is manageable, you can continue in the loan and keep getting tax benefits.
I have taken loan for a let-out property. What should I do?
For a let-out property, there is no cap on tax benefit for interest payment. Hence, for Rs 60 lac loan, you will deduction for entire Rs 5.96 lacs of interest paid in the first year.
Tax benefits are better for a let-out property.
Though the tax benefit of principal repayment is still capped, you get tax benefit for entire interest paid.
If it is your second house, make the most brutally rational decision. Find the post-tax cost of your loan. By the way, let-out property can even be your first house.
For a person in the 30% tax bracket, the cost of a 10% loan for a let out property will be 6.91% p.a. The cost will be 7.94% and 8.97% per annum for borrowers in 20% and 10% tax bracket respectively.
The cost will be even lower if you are getting tax benefit for principal repayment too.
Once you find the post-tax cost of loan, it becomes a classical Prepay or Invest decision.
If you can find an investment that provides better post-tax returns than the post-tax cost of loan, invest or else prepay. Remember this is only for your second house.
Don’t get fixated with tax benefits on home loans.
Do the calculations and find out how much tax benefits you are really getting for your home loan.
It is quite possible that by prepaying (partly) your loan, you do not let go of too much tax benefit.
If it is your first house, do not get too rational. Prepay the loan aggressively or at least make it manageable. But yes, don’t get obsessed with home loan repayment.
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