Thumb rules to consider before applying for Loans (Home)
Simple Finance weekly newsletter (Week 10)
It is said “Home is where the heart is”
Let us discuss Home loans in this instalment of Thumb rules to consider before taking Loans.
Buying a home often has an emotional side to it. It gives a sense of accomplishment; it is a physical form of your savings. From the mid 1990s the Interest rates have fallen from upwards of 15% to 7.5% and the property price appreciation has made home as an investment attractive.
What are advantages of Home loan?
Prevailing interest rates are lower than in the past; depending upon the credit score, the amount sanctioned can be large and being a long tenure loan, the apparent burden reduces as your income grows in future.
Section 24(b) of IT Act, 1961-Deduction in income of 2 Lakhs for Interest paid as part of EMI (only after possession of the property is received, co-borrower who is co-owner of the property is also able to claim this exemption, in effect doubling the exemption amount).
As per Section 80(c)- Deduction in income of 1.5 Lakhs for the Principal paid in EMI, in the first year you can also avail deduction in income for stamp duty paid. In addition you can find out if you are eligible for 80EEA and PM Awas Yojana.
But saving tax on the income that is paid as interest (which not investment/not loan repayment) should not be your primary intention for taking a home loan.
Home ends up becoming the largest component of our portfolio, in addition to being one of the most illiquid forms of investment. You can not sell your 1 Crore house to pay for a need that costs 10 lakhs, it wont get sold sooner than 6 months too. Buying and selling a house involves many taxes, fees and commissions. Cost of homes in India has already run up a lot and the rise in the cost of homes today is because of rising costs of inputs like steel and cement and not increase in intrinsic value of the house. Rental Income has stagnated at 3% (of cost of property) per annum. The inventory/supply of houses is more than the demand. Work from home culture may also have an impact on tendency to buy/ rent a second home in a city of employment other than city of permanent residence.
Coming back to topic at hand, home loan can be taken for a home in which you are going to reside in, in that case it can not be considered as asset even after you have paid off the loan. Because once you consider it as asset, you are open to the idea of selling it and you have decided to move to a rented property or buy another house (relocation to another city or area/ upgrading the carpet area or amenities etc)
Primarily, do not let the total EMIs of all loans become more than 30% to 40% of your household Income. An age old rule for budgeting is 50:30:20 Rule where 50% of your monthly income will be spent towards all the necessary and unavoidable expenditures like Rent, Electricity, groceries, EMIs, broadband bills, fuel, medicines etc. after accounting for 40% for EMIs, you will be left with 10% for other expenses.
Next 30% are discretionary expenditures where creature comfort expenses can be made like eating out, movies, fancy coffee, clothes, electronics etc. Last 20% are the most crucial as this is the minimum that you need to keep aside and save up for future.
Generally it is seen that the loan amount is taken to a maximum extent of your eligibility, with maximum tenure possible and down payments are just as much the banks mandate you. But when the rate of interest moves in an upwards direction the interest portion in EMI would be more and you may end up increasing your loan tenure or the EMI goes up if you wish to keep the loan tenure constant.
Sample Calculation
Loan of 1 cr at 6.7% for 20 years. EMI would be 75,739 and total interest paid over 20 years would be close to 82 Lakhs.
Loan of 1 cr at 7.5% for 20 years. EMI would be 80,559 (5K more every month)and total interest paid over 20 years would be close to 93.35 Lakhs. If EMI is to be kept 75,732 then the loan tenure would become 23 years and 4 months. If the EMI is paid at 90,000/- then you can clear the loan in 15 years and 11 months, Interest paid will be 71.26 Lakhs.
Assuming Interest rates are going to go up from here onwards, As the rate of interest goes up, the amount of loan sanctioned also goes down for the same EMI, which will have an impact on the house that you can ultimately afford. So it will be wise not to stretch to the maximum while taking a loan. Accumulate for a bigger down payment (even if it means that it will take longer to buy a home), banks mandate you to put a down payment of 20%, try to put in more than that, be ready for a higher EMI, as seen in above example, if you are getting a loan of 1.25 Cr, go for 1 Cr loan and be ready for higher than EMI value of 85,000. You can accumulate the difference between EMI paid and 85,000 in a recurring deposit, this amount will act as back up if rates go up or for foreclosure/ part payment of the Loan. If one intends for Prepayment of the loan, it is advisable to be done in initial years when the interest portion is high in the EMI to save on interest. You may see the Amortisation schedule which is Home Loan Payment Schedule for break up of the EMI for Interest and Principal repayment.
Missing a home loan EMI will invite late fees(1-2% of EMI), penalties and even a penal interest along with dent in the Credit score. Even one missed EMI will reduce your credit score by 50-70 points affecting future prospects of getting a loan. After 90 days of default, your account will be classified as Non Performing Asset (NPA) and may invite action as per SARFAESI Act, 2002. Reach out to the lender for finding a solutions like grace period, reduction in EMI and increase in tenure etc in case of job loss or similar grave situations.
Do not forget the other expenditures like processing fees, brokerage, registration and stamp duty, GST(under construction property), interior design of the house. If you do not want to let this EMI have an impact on your other non-negotiable goals like emergency fund, retirement, Kid’s Education, marriage, vacation etc, you have to be very conservative in taking a high amount-long tenure loan. Do not empty all your accounts. It is not worth living a hand to mouth existence. Do not forget to take Term life insurance as discussed in last article.
Fixed or floating interest rates ?
Though there is an option of Fixed interest rate, it is offered at a higher than prevailing rate. Even the fixed rate loans get converted into floating rates, Purely Fixed rate loans are not available today. Since this loan being a long tenure one, there will be cycles of upturn and downturn in interest rates. It would be wise to go for a floating rate loan.
One downside of loans is that it may hold you from catching a better investment opportunity as large part of your salary is already committed and makes you risk averse in terms finding other job or starting a business.
Increment in income- prepay loan or start/increase SIP with the amount.
It was suggested by some advisors to invest 30% the EMI in addition to EMI in a Mutual Fund every month and after every couple of years if you have made a profit, then sell those mutual fund units and prepay the home loan. This will enable you to prepay the home loan before tenure to avoid paying massive interest. Investing more is merrier but this process may not be suitable for all as there will be taxes, exit loads etc and it is not necessary that you will make profit every couple of years, you may end up earning a negative return.
But investing more is always a good idea. Instead of taking home loan and then start investing, it should be the other way around. You should focus on gathering more down payment, take a smaller loan and it is always easier to pay off a smaller loans to save on paying interest.
When your income increases, many also suggest not to close down the Home loan as it is the cheapest form of loan and it comes with a Tax benefit. With the extra income, they suggest to put it to a “better use” and invest in equities. But one of the first tenets of Financial Independence Retire Early (FIRE) movement, tells us to close down the debts and then start your saving-investment journey.
Not taking/Closing down home loan is all the more important if you do not want to be locked to a particular area, neighbour and square footage. So as you receive bonus and yearly increment in salary, start paying one EMI more every year or increase the amount of EMI by 5%-10% every year and see the miracle of reduced tenure and savings on interest paid. Your 20 years loan tenure will easily decrease by around 5 years as seen in the sample calculation.
Even more important step prior to taking a home loan is to identify a good property, for which there are few documents which need to be gathered and cross verified like
clear title
never buy a property from a GPA holder for the sake of avoiding paying registration fees as GPA can be revoked.
a channel document tells the history of ownership,
encumbrance certificate tells about any mortgages (unregistered lenders may not be captured here).
make sure that the carpet area and other measurements are as per the agreement,
the building has received a completion/occupancy certificate,
property tax payment receipts can be used to cross verify the ownership,
carpark allotment letter, make sure the payments of water, maintenance, electricity are paid up.
You can take professional help of an advocate to find out if the property has a clear title and not involved in any disputes.
It is sarcastically said that “Home is where mortgage is”.
To have a happy home owning experience, make it a long term goal, accumulate money in ‘Dream Home’ piggy bank and if fortune favours, you may not even have to go for a loan.
Finally decide which stability and settlement you need in life.
Start earning, buy a home, to settle down in life
or
Start earning, plan a home, start your journey to becoming wealthy and financially free.