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The two aspects of personal finance that have been relentlessly marketed as something close to panacea are SIP in MF and tax breaks through home loans. You may want to read about the SIP aspect in this earlier post. In the current post I will talk about home loans and try to examine the real picture.
Now everyone from your family, friends, neighbors and financial advisers of all other ilk would have told you that the home loan is a great product. Even several years back, when loans were considered to be a bad thing in India, home loans were considered to be a “good” loan. In fact, the huge push for owning homes by the middle class that started in 1990 was really started by the tax breaks offered by the home loans. Today, when loans have become commonplace and do not have any stigma attached to them, home loans are seen to be an obvious choice for almost all people.
Before we examine home loans in greater detail from a financial aspect, let us first understand the basic need for the demand of it reaching such levels. If you want to buy a house in any Metro city in India today, you will probably spend about 50 lacs for a 2BHK apartment. Assuming you want to pay for it on your own, it will at least take you a decade or more to invest and have that amount available. With the societal pressure from everywhere, along with your own needs when you start a family, owning a own home faster becomes a priority. As long as you can put down about 20 % from your end and have a seemingly stable source of income, loans are available easily too. You can take a loan of 40 lacs for 15 years, pay 45000 Rs as EMI and feel great about shifting to your own home. On top of it you get a tax break on the interest payment, whereby your tax outgo reduces by about 70000 Rs if you are in the highest tax bracket.
If you want to buy a house relatively early in life then home loans are a very useful thing. But the point of this post is to examine whether or not it makes financial sense too. Let us first examine the tax break part. The benefit here is really not what most people would have you believe. On a 40 lac loan at 10 % interest, your first year payments will be nearly 5.4 lacs and interest payment is about 4 lacs. You are getting a benefit of reduced taxes to the extent of 70000 Rs by paying this 4 lacs interest. But then you are staying in your own home and the asset price appreciates over time.
So now let us look at the overall picture once more from a cash flow angle:-
- Initial cash outflow for down payment in year 1 = 10 lacs
- EMI outflow @ 45000 in the first year = 5.4 lacs
- Rent saved @15000 Rs in year 1 = 1.8 lacs
- Tax saved on home loan interest = 0.7 lacs
- You are therefore paying an interest of 4 lacs in year 1 and saving 2.5 lacs overall.
This does not suddenly sound so good, right? Over a 15 year period you will be paying an interest amount equivalent to the principle amount. The total tax saved will be equal to about 10.5 lacs, assuming the tax breaks continue. So in essence you are paying 40 lacs in interest payment, in order to get a tax benefit of 10.5 lacs.
Obviously, if one can afford to buy a home without loans, it will be a great idea. However, for most of us that is not possible in practical terms. We need to understand that benefits of buying a home are from an emotional angle of security, to make sure that you are not subjected to the whims of your landlords and to invest in an asset that may well appreciate.
Get a home loan for all of the above reasons and not for the tax breaks that it gives you. We need insurance even though it is an expense. See the interest paid on home loans as an expense you need to incur as you do not have enough money to buy a home outright. The tax break is a bonus but it definitely can never justify taking a home loan. Also with increasing prices the tax break is only available to a portion of your interest payment only.
In conclusion, there are unfortunately no good loans. All loans make you pay fairly high rates of interest. You need them if you do not have the resources to pay outright. Therefore, a prudent course of action is to pay your loans quickly if you can.
In the next post we will examine a strategy for pre-payment of home loans.