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Do not overestimate tax benefits on home loan repayment

Do not overestimate tax benefits on home loan repayment

Do not overestimate tax benefits on home loan repayment
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By Deepesh Raghaw  Jul 24, 2019 8:47:18 AM IST (Published)

Home loan borrowers do not want to prepay their loan just because of associated tax benefits. I do not deny that home loan repayment comes with tax benefits bringing down the effective cost of the home loan. However, sometimes, these tax benefits on home loans can be overrated.

You have some cash in hand because of the recent annual performance bonus that you received. You have not yet decided how to use that money. You have no credit card or personal loan which needs to be settled at a high priority. You only have a home loan but you are not planning to part prepay it because you will lose out on tax benefits.

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This is a common refrain among home loan borrowers. They do not want to prepay their loan just because of associated tax benefits. I do not deny that home loan repayment comes with tax benefits bringing down the effective cost of the home loan.
However, sometimes, these tax benefits on home loans can be overrated.
Since the tax benefits are capped, you may not get as much tax benefit as you think you are. In fact, you may pay off part of the loan and still get almost similar tax benefits.
Tax Benefits of Home Loans
  1. Deduction in total income by up to Rs 1.5 lakh for principal repayment under Section 80C of the Income Tax Act
  2. Up to Rs 2 lakh for interest payment for a self-occupied property under Section 24 of the Income Tax Act. For a let-out or a deemed let-out property, a cap has been introduced by capping the loss under income from House Property (for set off at Rs 2 lakh).
  3. There is additional tax relief under Section 80EE and Section 80EEA. However, there are many restrictions in the form of quantum of loan, date of loan sanction. Hence, such tax benefits may not be available to everyone. Therefore, for analysis under this post, I have not considered tax benefit under Section 80EE and 80EEA. If you are eligible, do consider such tax benefits too.
  4. Let’s see why income tax benefits for home loan repayment are exaggerated.
    You may get limited Tax Benefit for Principal Repayment
    1. You may be re-paying more than Rs 1.5 lakh of principal in a financial year. The tax benefit is capped at Rs 1.5 lakh per financial year.
    2. Even if you are paying less, your other Section 80C investments such as PPF, EPF, ELSS, insurance premium, etc may exhaust the entire or major portion of Rs 1.5 lakh even before principal repayment comes into the picture.
    3. You get tax benefit for principal repayment only once you get possession of the house. Principal repayment done before the financial year in which you got possession of the house does not get you any tax benefit. This assumes importance for tax-payers who have purchased an under-construction property.
    4. You may get limited Tax Benefit for Interest Payment
      The tax benefit for interest payment is capped at Rs 2 lakh per financial year for a self-occupied property. So, if you are paying more than Rs 2 lakh interest in a financial year, the excess interest paid won’t fetch you any tax benefits.
      During the initial years of your home loan, a major chunk of your EMI goes towards interest payment while it goes towards principal repayment during the later years.
      Therefore, if you have a high-value loan, the interest payment in the initial years will be much larger than Rs 2 lakh.
      In addition, you do not get tax benefit for interest payment (for the self-occupied property) before possession. Even though you can claim tax benefit for pre-possession interest once the construction is complete in 5 equal installments, you will pay interest in the post-possession years too. Since the total benefit is capped at Rs 2 lacs, you will have to assess how much benefit you really get for interest payments. Moreover, if the construction is not completed within 5 years of taking the loan, then the tax benefit goes down from Rs 2 lacs to Rs 30,000 per financial year.
      Illustration
      I consider two loans of Rs 30 lakh and Rs 60 lakh, interest rate of 10% and a loan tenor of 20 years.
      Home loan tax benefits overrated Tax benefits of home loans
      For Rs 60 lakh loan, you are paying much more than Rs 2 lakh per annum in the initial years. In the first year, you have to shell out Rs 5.95 lakh towards interest payment. However, you get the tax benefit only to the tune of Rs 2 lakh.
      Moreover, if you see, for the first 11 years of loan repayment, the benefit for interest payment of Rs 30 lakh loan is same as tax benefit for Rs 60 lakh loan i.e. Rs 2 lakh per annum.
      Hence, even if you had prepaid Rs 30 lakh in Rs 60 lakh loan, the tax benefit for the interest payment wouldn’t have gone down by much.
      I have not considered tax benefit for principal repayment as the tax benefit is not exclusive. It is quite possible that your EPF/PPF contributions, ELSS investments or life insurance premium already amount to more than Rs 1.5 lacs. In such a case, you will not any tax benefit for principal repayment because the Section 80C limit is already over.
      In your case, if you have planned your investments in a way that you are getting some benefit for principal repayment, you can work out these numbers for your loans and find out the impact of pre-payment on tax benefits.
      It is quite possible that, with your loan particulars, you may get greater tax benefits. For instance, if your loan amount was only Rs 20 lakh, your interest payment for all the years will be less than Rs 2 lakh per annum. In such a case, you will lose out on tax benefit for interest payment in case of part-prepayment.
      However, come to such conclusion only after you have done these calculations.
      Hence, if you are holding yourself back from making the home loan pre-payment just because of tax benefits, think twice. You may not be getting as much tax benefit.
      If you are facing issues in calculating numbers, you can go to EMICalculator to find out the annual principal and interest payment for your loan.
      You need to make home loan amount manageable
      In my opinion, not every decision should be a financial decision.
      If the loan under consideration is for the house that you or your family plans to stay in for a long time, you should be reasonably aggressive in closing down the loan. This will apply to most first time home buyers.
      You do not want to leave your family a loan of Rs 60 lakh to settle.  You might argue that you have purchased a term life insurance which should be sufficient to settle the home loan amount. By the way, do you have enough life insurance?
      However, there are other reasons which might affect your repayment ability such as a prolonged illness, loss of job, accidental disability or disability due to illness. For some of these events, you cannot even purchase any insurance. Even if you do (like personal accident cover or critical illness cover), the insured event is not so objective in these plans (as in life insurance). Insurance companies have a lot of discretion. You know what that means.
      What will your family do if such an event were to happen?
      In my opinion, if it is your first house, do not think too much about tax benefits. Prepay the loan aggressively to make it manageable. This will also provide financial security and emotional comfort to your family.
      What is a manageable home loan amount? It depends. In my opinion, it should be an amount that your spouse can manage to repay on his/her own. If your spouse is non-working, it should be the quantum of assets that you wouldn’t mind disposing of to repay the loan fully. Of course, such sale shouldn’t affect your other financial goals.
      If your home loan amount is manageable, you can continue in the loan and keep getting tax benefits.
      I have taken a loan for a let-out property. What should I do?
      For a let-out property, there is no cap on tax benefit for interest payment. Hence, for Rs 60 lac loan, you will deduction for entire Rs 5.96 lacs of interest paid in the first year.
      Earlier, there was no cap on tax benefit for the interest payment for a home loan to purchase a let-out property. You could get tax benefit for the entire interest paid. However, Budget 2017 changed that. Budget 2017 capped the loss under Income from House Property to Rs 2 lacs per financial year. Any excess loss can be carried forward. Still, the tax benefit is slightly better than a self-occupied property.
      To understand this better, let’s take a deeper dive into how tax benefits on interest payment for home loans are accounted.
      We need to refer to three sections from the Income Tax Act.
      Section 23: defines how to calculate the annual value from your property (Income from house property). It specifies that the annual income from a self-occupied property is considered NIL. And you can declare up to two properties as self-occupied properties (there are conditions to be met).
      Section 24: defines deductions that you can apply to the aforementioned income from house property. It specified Standard deduction (30% of annual value). Note this Standard deduction is different from Standard deduction (Rs. 50,000) on your salary. It specifies deductions (Rs 2 lacs or Rs 30,000 as the case may be) for interest payment on a housing loan for a self-occupied property. Additionally, the total interest deduction for one (or more) self-occupied properties is capped at Rs 2 lacs per annum. This section does not place a cap on deduction on interest payment on let-out (or deemed let-out properties).
      Income for House Property = Income from house property (as per Section 23) – Deductions as per Section 24
      Alternatively,  Income for House Property = Rental Income (including notional rent) – Standard Deduction – Interest payments (subject to caps)
      And this can also result in a loss.
      Section 71 caps the set-off of Loss under Income from House property (against other income heads) to Rs 2 lacs. This clause was added after the announcement in Budget 2017. Clearly, if you are paying off a home loan for a self-occupied property, this rule change does not affect you. However, if you are repaying a loan for a let-out property, this rule can bring down your tax benefits.
      Let’s see how.
      Suppose you have taken a home loan for a self-occupied property. You pay Rs 3 lakh in interest in that year. We know that the Annual Value (and standard deduction concomitantly) from a self-occupied property is NIL. You can take a deduction for only Rs 2 lacs of interest.
      Income from house property = NIL – NIL – Rs 2 lacs = -2 lacs
      So, your loss under income from house property is Rs 2 lacs. So, you are not breaching the limit of Rs 2 lac set under Section 71. You use this loss to set-off against other income heads (salary, profession, etc). And this is how Interest rate deduction of Rs 2 lacs translates into tax benefit for you.
      Now, let’s say you have taken a loan for a let-out property. You pay interest of Rs 4 lacs in that year. Annual rental income is Rs 1 lac. Standard deduction will be Rs 30,000 (30% of Rs 1 lakh).
      Income from house property = Rs 1 lakh – Rs 30,000 – Rs 4 lakh = Loss of Rs 3.3 lakh
      The loss under Income from house property is Rs 3.3 lakh but you can use only Rs 2 lakh for set-off (Section 71). The remaining loss of Rs 1.3 lakh can be carried forward in the subsequent financial years.
      Now, if you had both these loans (one of self-occupied and the other one for let-out),
      Income from House Property = (Rs 1 lac + NIL) – (Rs 30,000 + NIL) + (Rs 4 lacs + Rs 2 lacs*) = Loss of Rs 5.3 lacs
      *For self-occupied property, interest deduction is capped at Rs 2 lacs.
      However, the setoff will be available only for Rs 2 lacs worth of loss. Remaining loss of Rs 3.3 lacs can be carried forward. If you examine closely, you are not getting any benefit for interest payment for the loan for the let-out property (the self-occupied property exhausts the entire limit) in the year.
      We need to consider such aspects when you assess the true cost of your loan. Earlier, you could have simply adjusted the interest rate by your tax slab rate to arrive at the effective cost of home loan for the let-out property. For a person in the 30% tax bracket, the cost of a 10% loan for a let-out property would have been 7% p.a (6.88% after cess). The cost will be 8% and 9.5% per annum for borrowers in 20% and 5% tax bracket respectively. The cost will be even lower if you are getting the tax benefit for principal repayment too. This is no longer the case. And the calculations are much more complicated.
      Once you find the post-tax cost of the loan, it becomes a classical Prepay or Invest decision.
      If you can find an investment that provides better post-tax returns than the post-tax cost of the loan, invest or else prepay.  Remember this is only for your second house.
      If it is your second house, make the most brutally rational decision. Get your calculations right. Find the post-tax cost of your loan.By the way, the let-out property can even be your first house. So, you need to plan accordingly.
      Personal Finance Plan Take
      Don’t get fixated with tax benefits on home loans.
      Do the calculations and find out how much tax benefits you are really getting for your home loan.
      It is quite possible that by prepaying (partly) your loan, you do not let go of too much tax benefit.
      If it is your first house, do not get too rational. Prepay the loan aggressively or at least make it manageable. But yes, don’t get obsessed with home loan repayment.
       
      Deepesh Raghaw is a SEBI registered investment advisor and founder of www.PersonalFinancePlan.in. You can read the original article here.
      Read all his columns here.
      Check out our in-depth Market Coverage, Business News & get real-time Stock Market Updates on CNBC-TV18. Also, Watch our channels CNBC-TV18, CNBC Awaaz and CNBC Bajar Live on-the-go!

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