Should you prepay your home loan?

Many advocate prepaying home loans in times of rising interest rates. But you need to evaluate the returns from savings you plan to liquidate, and the tax benefit from the home loan, before making such a move.

Interest rates on home loan have gone up substantially in the last one year. The rates have gone up from around 7.5 percent in 2005 to nine percent in 2006, and further to around 12 percent at present. This has led to an increase in the equated monthly installments (EMI) in the last one year by around 23 percent and by 37 percent since 2005.

As the interest rates on home loan have skyrocketed, many borrowers are considering prepayment of the loan from their savings. But, you should just not rush to withdraw your savings, like provident fund, to prepay a part of the home loan. Borrowers must evaluate the net cost of the home loan before deciding to prepay it.

First of all, you should try to find out the net cost of your home loan after adjusting for tax benefits. Then, you should ascertain the returns your savings are generating. If the net rate of return of your savings is higher than the net cost of your home loan, you need not retire the loan by dipping into such savings. But, if the return from a particular investment is lower than the net cost of home loan, it will be a smarter move to prepay the home loan from such savings.

There is no penalty for prepaying of your home loan from your savings. Only if you borrow from a bank to prepay the home loan from another bank, the other bank will ask you to pay a prepayment charge at two percent of the outstanding amount.

Tax benefit

First, you should ascertain the tax benefit that you get because of repayment of the home loan. According to Section 24 of the Income Tax Act, you will get a benefit of deduction up to Rs 1.5 lakhs from your taxable income against the interest payment for your home loan. Similarly, under Section 80C, your taxable income will get reduced by the principal up to Rs 1 lakh repaid during a year. Now, take for example, if you have borrowed an amount of Rs 30 lakhs for 20 years at 12 percent, your monthly installment will be Rs 33,033. That means,your annual installment will be Rs 3,96,396. Out of this, Rs 3,57,930 is adjusted against the interest and the rest Rs 38,466 is used to repay the principal.

Under Section 24, you will get a deduction of Rs 1.5 lakhs against the interest payment. And Rs 38,466 will be deducted from your income against the principal repayment. Therefore, a total of Rs 1,88,466 will be deducted from your taxable income. At the rate of 30.60 percent, including the two percent education cess, you will get a tax benefit of Rs 57,671. That means, you saved Rs 57,671 because of the home loan. That means, the net interest outgo came down to Rs 3,00,259. As the principal is Rs 30 lakhs, the effective interest rate in the first year is 10.01 percent.

In the second year, as the principal amount reduces by Rs 38,466, the net interest payment comes down to Rs 3,53,052. And the principal repayment portion will go up to Rs 43,344. Therefore, the total deduction allowed under both Section 24 and 80C will be Rs 1,93,344. This will lead to a tax savings of Rs 59,163. And, this will lead to net effective rate in the second year to 9.92 percent. As time passes, interest portion in the EMI will keep on declining and principal repayment portion will keep on increasing. So your tax benefit will keep on going up till the principal repayment portion goes up to Rs 1 lakh. As shown in the chart, your effective interest rate on the home loan will keep on declining for the first five years.

In the case of a Rs 50 lakh loan for 20 years at 12 percent, in the fifth year itself, the principal portion will cross the Rs 1 lakh limit and the tax benefit will be capped at Rs 84,000 at the rate of 33.66 percent including 10 percent surcharge and two percent education cess assuming that those who borrowed Rs 50 lakhs will have an annual income of more than Rs 10 lakhs. But, the effective rate will further come down to 10 percent in the sixth year.

That means, if you have money lying idle in the savings account, where you are earning a return of 3.5 percent, you must prepay the home loan from such savings. But, your provident fund earns a pre-tax return of over 11 percent if you are in the 30 percent tax bracket. Similarly, if an investment in mutual fund is giving you more than 10 percent return, you should not retire the home loan from such savings.