Choosing & Managing a Home Loan Wisely

I was talking to a friend recently who was planning to buy a house.

No, I did not convince him to continue staying on rent. 🙂 His life, his decision and who am I to tell people about their big decisions.

Nevertheless, we got discussing home loans and how the loan repayment works.

I was surprised to see that he had some misconceptions about the loan EMIs. Essentially, home loan EMIs are made up of 2 parts – the principal amount and the interest on the principal amount divided across each month in the loan tenure. He wrongly assumed that equal parts of the principal and interest are paid to the lender every month. This isn’t correct.

Have a look at the following loan repayment table below and then we discuss:

As is evident from the above, the interest component paid is higher during the initial years. During the latter years, the principal component is higher. With each passing month’s EMI, the interest paid decreases and the principal repaid increases. Many people know this. And many (like my friend) don’t know it.

So don’t think that if it’s a 25-year loan, then you would have paid back half your loan in 12-13 years. The actual amount you have repaid would be about 23-24% only.

If you have a home loan, just ask your lender for the home loan amortization table. It will indicate what exactly is your outstanding home loan amount at any point in time. Or you can easily get a quick idea of the same using online loan amortization table calculators.

Choosing a Home Loan

This is a very generic question. What I mean here is that after you have finalized the house you want to buy, how do you decide on the home loan amount, loan tenor, loan EMI, loan interest rate, etc.

Let’s see what all points you should consider when finalizing the home loan. And I will try to make this very simple:

• Lenders expect you to bring in about 15-20% of the cost as down payment. But I feel that a larger down payment (like maybe 30%) can also be considered. This means that you take a home loan equal to about 70% of the cost.
• Loan tenor and EMI are linked. Longer the loan tenor, smaller the EMI. Shorter the loan tenor, higher the EMI. What you need to understand is that lenders will give you a loan so that the EMI is maximum of about 40-45% of your income. Now let’s say you earn about Rs 1 lac per month. So your loan EMI can be Rs 40-42,000. Now you wish to take a loan of Rs 50 lac. And you want to keep a short tenor of 15 years. But for that, the EMI works out to be about Rs 50-51,000 – which is more than what lender would allow your EMI to be. But if you increase the loan tenor to 25 years, the EMI for the same loan amount comes down to Rs 41-42,000 – which fits into lender’s criteria for you. But longer tenor also means higher total interest payout. So at times, you need to change your tenor to fit your EMI budget (self-affordability or lender-mandated) even if it means higher interest. I have written in detail about the dynamics or loan interest, EMI and tenor at How shorter home loan tenor can save you lacs?
• But all said and done, I think limiting loan* EMIs to 40-50% of income is max that you should go. As you need money for regular expenses and saving for other goals too. (*for all loans and not just home loan)

Managing a Home Loan

The home loan has been taken.

Now comes the difficult part. Paying it back. 🙂

And for all normal people like us, loans are fairly predictable and have to be paid back on time. Some are lucky who don’t need to pay back their loans. 😉

Nevertheless, managing home loan is important.

Ideally, you would want to close it soon, pay as low interest as possible and if possible, invest elsewhere too as effective after-tax home loan rates are pretty low.

But at times, people get too influenced by tax saving and don’t think through clearly. And then there are others who have an obsession with loan repayment and early closure. They end up taking a holiday from investing when repaying a loan and that can be very harmful.

But let’s handle one thing at a time. Let’s first revise the tax benefits available for home loan borrowers:

1. Up to Rs 1.5 lac deduction allowed for principal repayment under Section 80C of the Income Tax Act. Unfortunately, this deduction is also applicable to other things like EPF contributions, insurance premiums, tuition fees, etc.
2. Up to Rs 2 lac for interest payment for a self-occupied property under Section 24 of the Income Tax Act. For a property that is let-out or deemed to be let-out, there is no cap on tax benefit available against interest payment.

Do you remember what we discussed little earlier about % of EMI going towards principal repayment and % going towards interest payment? Let’s make use of that concept to understand another thing:

During the initial years, a major chunk of EMI goes towards interest payment. Therefore, if you have a big loan, then the interest paid during the initial years will be large. And possibly much larger than Rs 2 lac.

Now if this is your first house purchase and you use it, then the tax benefit for interest payment is capped at Rs 2 lacs per financial year. So even if you are paying much more than Rs 2 lacs interest per year, the excess interest paid (above Rs 2 lac) won’t fetch any additional tax benefits.

So if you are among those who want to close the loan as early as possible but are not doing it thinking that it will reduce your tax benefits, then check again. It’s possible that you are not even getting as much tax benefit as you think you are getting.

But I agree that the tax benefits for a let-out property are better. So loan prepayment strategy should look at all aspects.

Let’s see at some more points that should be kept in mind while managing your home loan. And I will try to make this simple:

• Your loan tenor may be long, like 25-30 years. But I feel that you should aim to close it earlier. You may feel its better to let it carry for mathematical reasons, but I have this view that you should prepare yourself for early closure if your finances allow. Will discuss this shortly.
• Remember, that loan repayment is not the only thing in your life. You have other important financial goals that need separate savings. Like children’s education, your retirement, etc. You really cannot just focus on one thing as the delay in saving can set you back by a lot.
• So after accounting for your regular expenses, base home loan EMI and regular investing for other financial goals, if you have a surplus left, then you can consider prepayment of your home loan.
• Broadly, you have two options.
• First, prepay some amount every year. This can be done either by paying extra money with every month’s regular EMI or you can save up some money for few months (or use annual bonus) and prepay a chunk in one go every year.
• The second option is for more aggressive people. You start investing the surplus money every month in an instrument which you may refer as Loan-Clearance Fund or whatever you wish. This can have equity funds too. So you keep adding money to it every month and allow the corpus to grow for some years. Once the corpus size grows to match the outstanding loan amount, you can use it in one shot to close the loan. If assumed maths of equity giving 12% returns and home loan costing 7% (after taxes) works out, you will mathematically close the loan very early and save a lot of money in interest too.
• Basically what is happening in the second option is that you are parking the surplus every month meant for prepaying the home loan. But you are postponing the prepayment to a later date. With time, this will become a buffer for you too. If in some month’s you have sudden unplanned expenses that force you into a corner, you can use this fund to pay your EMIs. If RBI decides to increase interest rates and make them too high, then you can again use money from this fund to prepay and reduce the outstanding loan amount. Works well in most cases.

The home loan along with other circumstances of the borrower offers tons of permutations and combinations that can be analyzed. As a borrower, you should consider everything that is possible and then chose what’s most practical for you in your unique situation.

You may do any of the following and you will still be right:

• Continue paying original EMI for full loan tenor.
• Increase your EMI every year or two to reduce the interest outgo and the tenor.
• Continue regular EMIs and use your annual bonus (partially or fully) to prepay once a year.
• Continue regular EMIs and save surplus in equity-oriented funds for several years and hope for good returns and then close the loan in one shot when the value of your investment exceeds outstanding loan amount and become loan-free.

There is no right or wrong or ideal answer here. Every situation demands further analysis and then taking a call.

Always remember that your primary responsibility is to ensure that you pay all your loan EMIs on time. This, in turn, improves your credit score. In fact, lenders always look at your credit score even before approving the loan applications. It will do you good to check out free cibil score for yourself before you apply for home loans. You will know in advance what the banks might tell you. And if the score is good, then you can even negotiate harder with the banks to give you lower interest rates. There are options to take a personal loan for low cibil scores but that won’t help in case of home loans. So its better to find out your credit score and then decide to go or not go for the home loan. You can always first improve your score and then apply for a loan.

Note – If you are yet to buy a house using a loan, don’t go overboard if home loan rates are falling and property prices are down. Always assess your individual financial situation whether to go for a loan-funded property purchase or not.

Once your loan payment is on track, you should focus on goal-based investing and start investing for your critical financial goals. After all, money is not just there for accumulation. It should be used to achieve your real life goals. Isn’t it?