You just happen to sell off the ancestral property that fetches you a great deal of money! Well, no doubt it’s a great feeling, but it puts you in a dilemma. Should you pay off your housing loan? Honestly, home loan foreclosures is a wise decision as it brings down your overall cost of the property by reducing your interest outgo. But, the decision-making process is the tricky part, where most borrowers get confused. It's important to factor in the pros and cons of a home loan foreclosure, so read on!
Let’s start with a typical financial lesson that most of you might be aware of. The two sides of interest rate i.e.
- The paying side
- The gaining side
It’s obvious that every one of us wants to remain on the gaining side. But how do you do that when you have loans which makes you remain on the paying side! Well, there’s definitely a workaround to save some interest cost by making early payments on your loans that can help you save a lot of money.
But then again, is it advisable to simply pay off your loans when you have surplus cash?
Well, that’s where the dilemma starts. So let’s understand:
Is it Good to Prepay Home Loans? – The Dilemma:
Unfortunately, there’s no mathematical formula that helps you derive this answer. But of course, if you consider various factors and take into account your financial planning, you can easily come to a conclusion.
Basically, it all boils down to either of the two decisions. So let’s discuss the factors that affect our decision:
Factors That Decide Your PrePayment Ability:
- Financial Planning: All thanks to the 30-year mortgage/housing loans, a large chunk of your EMIs goes into making payments of the interest cost. With a booming real estate market and a surge in demand for premium residences, it gets even harder to own a house with ‘owned capital.’
Simple math, if you have a home loan of ₹3,000,000 at 8.50% interest rate for a period of 30 years, you’ll be paying a sum total of ₹5,304,266 in interest dues (if you follow your regular EMI schedule.)
Now consider this – Out of the entire loan, you have a balance of say ₹25 lakhs outstanding on your principal (that you can pay off using your owned funds). In case you happen to pay off this outstanding loan amount, you can save approximately ₹22.75 lakhs in interest cost, not to mention, your standard of living goes up with the savings in EMI outgo among other benefits.
Now, this gives you a reason to think that you should definitely pay-off your home loans. But a word of advice, only makes prepayments when you have surplus funds to meet your requirements.
- Idle Cash: Imagine a scenario where you have surplus funds lying idle in your bank account, earning no or just a little interest. Well, you don’t even plan to use such funds any time soon. These funds might be a result of your savings, maturity of small investments or an annual bonus for your hard work that paid off!
This is a case where you’re paying higher interest cost than you’re earning and it’s definitely advisable to utilize such funds in paying off your home loans. Making small prepayments makes a huge difference and saves you a good amount in interest cost while lowering your EMI burden. Such small but frequent prepayments can give you peace of mind and you can eventually expect a better lifestyle and good financial growth, for you’ve definitely made a smart decision!
Factors that Determine When Should You NOT Make PrePayments:
- Taxation: Having a home loan has its own advantages when we take the aspect of taxation into the account. The interest payment that you make on your home loans is a tax-deductible expense under ‘Section 24’ of the Income Tax Act and you can claim a deduction of up to 2 Lakhs per annum. Additionally, the payments made under the principal component of the loan are eligible for a deduction under ‘Section 80c’ up to a maximum limit of 1.5 Lakhs.
If you fall in the higher tax category of 30%, considering the tax benefits on total 3.5 Lakhs (Interest + Principal Components), you can save a maximum up to 1.09 Lakhs on income tax and surcharge that will help you bring down your overall interest cost. So, it’s advisable to evaluate your taxation before paying off your housing loans.
- Ability to Generate Higher Returns: ‘Opportunity Cost’ is something that many people ignore when it comes to Financial Planning. Imagine you have a home loan of Rs. 30 Lakhs having an interest rate of 8.50%. Now, you have an equivalent surplus amount in hands that you can either utilize to pay off your loans or invest in various asset classes. When your investments are able to generate higher returns over and above your interest rate (say 12%), the difference 3.50% is the opportunity cost that you will forego in case you use such funds to pay off your loans.
Investments in equities and mutual funds have a proven record that has generated higher returns in the long term and if you have an appetite for risk, you should definitely consider the ‘Opportunity Cost’ and if you’re willing to take the risk, you should definitely make sound investment decisions that will help you make some money instead of losing it in paying off your home loans!
Well, it’s definitely a game of calculations and weighing the pros and cons. But to best utilize your funds, you should not rush to pay off your loans but weigh various options and make smart financial decisions that will help you create wealth with proper financial planning.