Buying a house is a major decision which most of us take at some or the other time in life. We have discussed various issues pertaining to owning real property in “Buying Real Estate- Will it be your asset or liability”. After factoring all aspects, if one wants to go in for a house, then he/she needs to work out the funding requirements. Except a few who have the capability to make cash down payment, most of us will have to fund the major portion of the cost through a housing loan. Also, the tax incentives associated with utilizing a housing loan make it a preferred option as compared to using own funds. Purchasing a house has lot of emotional and psychological context. Therefore we tend to overlook the micro aspects of home loan while going in for the big-ticket purchase.
The aim of this discussion is to highlight some factors and associated issues which can help minimize/optimize the financial costs & benefits. The important factors associated with home loan are the income, expenses, available funds, amount, rate, tenor and tax benefits/implications.
Right Amount of Home Loan
The overall home loan amount is but obvious the most important factor which is dictated by the cost of the house. Mostly the max amount permissible is the 85% of the project cost. The minimum amount required would depend on availability of own funds. It is advisable to retain sufficient liquidity to meet any planned or unforeseen expenses in coming years. The range between the minimum requirement and the maximum possible, is where the decision point lies.
The optimum amount would depend on the other factors like the rate & tenure which will indirectly decide the EMI. The monthly paying capacity would depend on the surplus available after catering for expenses and planned savings. As a general guideline, the monthly outgo on loan repayments should not be more than 50% of the monthly income. Keeping cushion for other loans like car/personal loan, it is prudent to limit the EMI on housing loan to 35-40% of monthly cash inflows.
Interest Rate
The rate of interest is not in our hands. But we can compare all available options and choose the best available. One needs to be careful in ascertaining the hidden costs, and calculate the actual implied rate.
One can use the Loan Amortization template of Microsoft Excel and check results with what the loan provider is offering. Once the figures pertaining to Amount, rate and tenure are filled, compare the resultant EMI. In case the actual EMI is more, then increase the rate till it equals the actual EMI, and that would be the implied rate. Try to understand the hidden costs which have increased the rate and negotiate with the lender to bring them down. Ensure that the rate is on reducing balance and not on flat rate. Further avoid/reduce any advance EMIs or processing fees.
Right Tenure of Home Loan
The tenure is something which is in our hands to a significant extent. Most loan providers give a minimum tenure of 5 years and maximum tenure of 30 years. For a given amount and rate, longer the tenure, smaller would be the EMI. But also larger the amount of total interest paid. So, the range of choice of tenure lies between the shortest tenure which should be limited to about 35% of monthly income, and the longest tenure which is generally thirty years. Somewhere in this range, one needs to find the optimally beneficial tenure.
Optimize the tax Benefits on Home Loan
As per the current provisions, the maximum amount of negative income from house property permissible for deduction in any year is Rs 2 lakh . Any negative income more than this can be carried forward for eight years. To avail of the entire tax benefit, one should aim to ensure that the entire interest paid is adjusted for tax deduction within eight years. A rough estimate of optimum/maximum tenures for various amounts of loan, at various rates of interest, which will ensure that the tax benefit is completely availed of, is as under:-
| Rate → Amount ↓ | 6.50% | 7% | 7.50% | 8% |
| ₹ 20,00,000 | 30 | 30 | 30 | 30 |
| ₹ 30,00,000 | 30 | 30 | 21 | 16 |
| ₹ 40,00,000 | 14 | 12 | 11 | 10 |
| ₹ 50,00,000 | 10 | 9 | 8 | 8 |
| ₹ 60,00,000 | 8 | 8 | 7 | 7 |
| ₹ 70,00,000 | 7 | 7 | 6 | 6 |
| ₹ 80,00,000 | 6 | 6 | 5 | 5 |
| ₹ 90,00,000 | 5 | 5 | ||
| ₹ 1,00,00,000 | 5 |
It may be noted that the available range gets diminished with increasing amount. At lower amounts one has more flexibility in choosing the tenure, but with larger amount, the space is smaller. Shorter tenure would also imply a larger EMI, therefore more often than not one would have to opt for an affordable EMI. This will lead to a tenure more than the optimum desired and loosing out on some tax benefits.
Example
Let us try to see these issues with the help of an example. Mr X has a monthly post tax income of Rs 1 Lakh and an accumulated corpus of Rs Thirty Lakh. He needs approximately Rs 15 Lakh for his planned financial objectives in next five years. He is also paying an EMI of Rs 8,000/- per month on car loan. His monthly expenses are about Rs 50,000/-. He also invests Rs 10,000/- per month in Mutual Funds for his other long-term objectives. Mr X is interested in buying a house costing Rs 50 lakh. He wants to work out the amount and tenure for a loan which will be available at 7 %.
Mr X can spare Rs 15 lakh from his accumulated corpus and therefore the minimum amount of loan required will be Rs 35 lakh. Further the maximum loan amount would be 85% of the cost which will be Rs 42.5 lakh. So, the range of his requirement as far as amount is concerned is small, ie between Rs 35-42.5 lakh. He is presently paying Rs 8,000/- as Car loan EMI and so the residual paying capacity is Rs 32,000/-. The total in this scenario would be Rs 40,000/- which will be 40% of his income.
Suggested Solution
The minimum tenure being 5 years, the max EMI would work out to approximately Rs 79, 000/-. This will be way above his paying capacity. If the loan tenure is 12 years, this EMI for Rs 40 lakh loan will be around Rs 41,000/-. This is again more than his current paying capacity. If he reduces the loan amount to Rs 35 lakh, this EMI will be approx. Rs 36,000/- which is again more than his capacity. But the optimal tenure for the reduced amount is higher (about 16 years). So, if he increased the tenure to 15 years, the consequent EMI would be Rs 31,500/- which will be within his capability. It appears that Mr X would be better off by taking loan of Rs 35 lakh at 7%, for a tenure of 15 years.
Conclusion
We can also not neglect other factors which would be contextual to any individual. Like pay raises, and any other stream of cash inflows which can influence his/her decision making. One needs to do some iterations before deciding on the final amount and tenure of home loan. This will help in maximizing the possible benefits, and reduce the overall costs.
There is also a general tendency to over estimate own capability. Under emotional decision making one ends up taking a loan much more than his/her affordability. This has a natural ripple effect on all other financial objectives. And one generally ends up in a debt trap of cyclic personal loans for prolonged durations. It is more prudent to accumulate adequate corpus before buying a house, so that the loan requirement is lesser. Also, if the need is urgent, one can initially opt for a smaller house. You can upgrade later when the financial conditions permit.