tax saving – Stable Investor

In India, home loans come with tax benefits. You already know that.

And there is no denying that these tax benefits make it all the more attractive to buy property using home loans.

But time and again I have seen people overestimating these tax benefits. Why?

Because the tax benefits available on home loans are capped. So depending on the home loan they take, the actual benefit may not be as large as what many borrowers think.

Now there are 2 components of a home loan – principal and interest. And the home loan EMI also has the same two components – (i) principal repayment, and (ii) interest payment.

So what tax benefits are available for Home Loan borrowers that can reduce their tax outgo?

Deduction of up to Rs 1.5 lac for principal repayment under Section 80C of the Income Tax Act.
Deduction of up to Rs 2 lac for interest payment for self-occupied property under Section 24 of the Income Tax Act. The interest payment of up to Rs 2 lac is available as loss under income from a let out property
Additional deduction of Rs 50,000 on interest payment, over and above the deduction claimed in Section 24 is available for the first time home buyers under Section 80EE.

Tax Benefits on Home Loan Principal Repayment

A deduction of up to Rs 1.5 lac is available for principal repayment of home loans under Section 80C of the Income Tax Act.

There are few things to note here.

First, Section 80C’s tax savings are also applicable on your investments in EPF, PPF, ELSS (Equity Linked Savings Scheme) and expenses like insurance premiums, school fee, etc.

So all these investments and expenses compete with home loan principal repayment for the Section 80C benefits. Chances are high that the sum of EPF + PPF + ELSS + insurance premiums + Home Loan Principal repaid will be higher than Rs 1.5 lac. If that’s the case, the cap of Rs 1.5 lac in Section 80C limits the benefit to just Rs 1.5 lac irrespective of what you claim from within EPF, PPF, ELSS, premiums or home loan principal repayments.

Even if you have a big loan and are repaying more than Rs 1.5 lac of home loan principal, the tax benefit is limited to just Rs 1.5 lac.

Tax Benefits on Home Loan Interest Payment

Deduction of up to Rs 2 lac is available for interest payment for self-occupied property under Section 24 of the Income Tax Act. And the interest payment of up to Rs 2 lac is available as a loss under income from a let out property.

This is where things get interesting and people get confused.

Due to the above-mentioned capping of benefit, even if you are paying more than Rs 2 lac interest in a given financial year, the excess interest above Rs 2 lac will not fetch you any tax benefits.

Here is a small example:

Suppose you take a Rs 35 lac home loan for 20 years at 9.5%. You EMI will be Rs 32,625 per month (read more about how home loan tenure impacts interest paid).

As you can see, in total Rs 3.91 lac is paid in EMIs in 1^st year. Out of this, principal forms only Rs 61,633 whereas interest is Rs 3.29 lac. Out of this Rs 3.29 lac, only Rs 2 lac is eligible for tax benefits under Section 24. The remaining amount (can be seen in red-colored text) cannot get tax benefits.

The home loans are structured like this that during initial years, a major part of your EMI goes towards interest payment. So it’s possible that the interest you pay in the initial years will be much higher than Rs 2 lac (the limit for tax benefit).

Let’s take another example to find out another interesting aspect.

We compare two loans. First of Rs 25 lac and the second of Rs 50 lac. The loan tenure and interest rate on both are 20 years and 9.5% respectively. The EMIs are Rs 23,303 (for Rs 25 lac home loan) and Rs 46,607 (for Rs 50 lac home loan).

Now have a look at the table below:

For the Rs 25 lac loan, the interest part that misses out on tax benefit is very small (Rs 35,616 in the first year and goes on reducing). But for the Rs 50 lac loan, you initially pay Rs 4.71 lac as interest in the first year. This is much more than the Rs 2 lac per year limit. So you only get the tax benefit on Rs 2 lac of interest (under Section 24). The remaining Rs 2.71 lac doesn’t get any tax benefit.

And if you focus on the table (on right) of Rs 50 lac loan, you will see that you keep having an interest component that misses out on tax benefits till the 15th year. And more interestingly, during the first 7 years of loan repayment, the tax benefit on interest payment of Rs 25 lac loan is the same as tax benefit on Rs 50 lac loan!

So much so and hue and cry for home loan tax benefits. 🙂

This is all the more reason why one needs to look at the tax angle when planning to prepay home loans. And if that wasn’t enough, there is also the dilemma of whether to invest vs prepay home loan – to benefit from higher returns elsewhere as compared to low post-tax home loan interest rates that are prevalent in India.

But I suggest that before you decide to prepay your home loan, you run your own numbers or get in touch with an investment advisor to help you out.

And if you are one among those who are still deciding whether to take a home loan or not, then I suggest that even before you begin your search for home loans online, some time should be spent to understand how home loans actually work and how best you can manage home loans once you take them.

The idea of doing this post was to highlight that at times, people get over excited when it comes to tax benefits from their home loans.

It is quite possible that you may not even get as much tax benefit as you thought you would be getting from your home loan.

Tax Saving alone will not help you much.

I agree that no one wants to pay taxes if given a choice. So, people try to avoid it to the extent that it’s legally possible with better and ultra-smart tax planning. But unfortunately, some people become so focused on saving taxes that they fail to see the forest in search of trees!

I know that for most people, trying to minimize tax obligations is like an annual pilgrimage. 😉

Investing to save taxes by itself serves a limited purpose. It’s best to align the idea of tax-saving with the overarching plan for your financial goals and then get the maximum benefit from the available tax-saving products. My general advice before proceeding would be to not focus too much on the best strategies for tax-saving products.

Tax saving should be a result of proper investment planning and not vice versa.

Making Tax Saving part of a Bigger Plan

Planning for financial goals and that for tax savings should not be a stand-alone exercise.

Those who focus on tax saving more fail to realize that at times, most popular tax-saving products may not be the right ones for the actual financial goals. A big example of this is mixing insurance with investments.

A goal-based financial plan gives investing a perspective and helps track one’s progress towards those goals. Such a plan will consider the income and savings capabilities of the individual, their financial goals and their risk profile. And then arrive at a tax-efficient plan to help achieve those goals.

Let me try and simplify it for you.

First, you need to be aware of your income. I know most people know all that stuff. But some still have confusion about how they end up getting the so-called ‘in-hand’ salary that is much lesser than what the company tells them as their annual CTC. 😉
Estimate your total taxable income for the year (including salary, rent, etc.). Don’t forget to deduct the exempted income (like HRA, LTA, etc.) from the total income while calculating taxable income.
Find out your tax liability for the year. Different people have different tax liabilities depending on which tax slab they belong to. You can take help of a CA or use income tax calculators that are easily available online. Do this even before you begin your search for best tax saving products or your actual investments.
Next factor in your expenses. Estimate how much your basic expenses that you really cannot do without are. Once that is done, you will know what scope you have for saving taxes by way of investing in different products under various sections of the income tax act.
Now you know few important things: Your tax liability and your ability to save (after basic expenses are taken care of).
Some tax saving can happen automatically via certain expenses. Like insurance premiums, home loan obligations, school fees, etc. Your mandatory contribution to EPF is also eligible for tax saving. So all these expenses and mandatory savings reduce the need to look for tax-saving products (partially or fully).

With the basics out of the way, now comes the important part.

Find out your real financial goals first (here is some help – detailed How-To Guide & Free Excel Download).
Once you are clear about your goals, you need to identify which investments options to choose to assign to each goal so that you can save taxes too.

Sidenote: Do note that I am focusing more on financial goal achievement and not just on tax saving. And that is the way to go. Do you wish to retire quickly or you wish to maximize your tax-saving by randomly investing in wrong financial products?

With goals identified and rationalized, use goal-based investing to choose correct investment products that can help you reach your financial goals. Tax efficiency is a secondary. Remember that. At best, it should be linked to the process of identifying suitable investment products.
There are several products that also offer tax benefits – like PPF (Free PPF Excel Calculator), ELSS funds, NPS, traditional insurance plans, NSC, some FDs, home loan repayment, EPF, VPF and whatnots… Evaluate the features of these products – risk vs return, tenors and lock-ins, flexibility in making investments and receiving amounts on maturity, etc. Also important is understanding the tax treatment – whether it’s EEE, EET or something else. Here again, you can use some tax guide or take help of an advisor to understand the nuances of these products.
Please remember that the actual product should be chosen in alignment with your unique circumstances in terms of ability to take risks, need for liquidity and investment horizon. One size doesn’t fit all. You cannot copy-paste someone else’s financial plan in your own life. That would be a huge mistake to commit.
And as far as possible, your tax-oriented investments that are already part of your existing portfolio should also be aligned with your financial goals.

Also, due weightage should be given to whether the choice of product should be in alignment with your overall portfolio’s required asset allocation.

As an example, if you are young and have the ability to save about Rs 1.5 lac, then it makes no sense to utilize it fully via EPF+PPF combination. Being young you should have a significant investment in equity – which here can be utilized via ELSS funds. Read more about how young earners should plan their investments.

Remember…

The purpose of investing is to achieve your financial goals and not just tax-reduction.

Read that again please.

A well thought out investment strategy is the core idea of a good financial plan. Some people know how to figure out a good tax-efficient strategy on their own. But for others, it’s best to seek proper advice from investment advisors (and avoid free investment advice).

A well thought out financial plan can help investors achieve their financial goals in a smart and tax-efficient manner. You can read more about smart financial planning to clear your thoughts.

Finally…

Talking about your tax-saving battles and victories can be glamorous. 🙂

But if that victory, i.e. maximization of tax saving comes at the cost of choosing wrong financial products, then you will lose out in the long term. And by the time you will realize about your mistake, it will be very (if not too) late.

Do yourself a favor and put in place a proper investment plan for yourself – so that your tax saving investments can contribute more to the overall portfolio and help you achieve your financial goals.

Last minute tax saving efforts will almost always lead to unwise decisions. So avoid waiting to bunch your investment decisions to the end of financial year (Jan-Mar).

However, if you are already late and you realize that… then make sure you don’t repeat this mistake again next year.

Find yourself a good financial advisor and talk to him. Engage him to put in place a good financial plan that you can implement when the next year (or financial year) begins. Give yourself a head start. Or if not now, put a calendar reminder to get in touch with an investment advisor as soon as possible.

Good tax saving investments are no doubt an opportunity for you to start your wealth creation journey. But remember that personal financial goal planning should precede your tax planning. Keep your financial needs in mind and then link your tax saving plans with your financial goal related investments.