If you want to buy a house, you have two options. Either take a loan or use your own funds. Most of us obviously would not be able to afford an outright purchase (without availing of any loan whatsoever). However, even those fortunate few who have the wherewithal to buy a house off the shelf, should avail themselves of a loan. Let us see why.
Well, for starters, interest outgo on the loan up to Rs. 1,50,000 is tax deductible. Moreover, the capital repayments are eligible for Sec80C deduction up to Rs. 1,00,000. Now, if one were to use one’s own funds, these benefits are forgone. There are absolutely no tax benefits available for someone who wants to buy his property outright without taking a loan! This does seem a bit unfair, but that’s the way the law is.
Now taking a step further. How much loan should you opt for? If you take a loan, you pay a higher rate of interest than what you earn on your own funds. So should you use your funds for buying the house? In that case, you lose the tax advantage.
Therefore, you have to weigh the benefit of the tax advantage of taking a loan against the loss due to higher interest outflow. Obviously, there is a break-even point which can help you in arriving at the optimal mix. The answer would of course depend upon variable parameters like the interest rate on the loan and what your own funds earn outside.
Let us try and find out what it is with an example.
We assume that one Mr. Mistry has taken a housing loan of Rs. 20 lakh @9% p.a., whereas his owned funds earn just 6.34% p.a.. The reason why I have chosen this curious figure of 6.34% will become clear in a while.
Anyway, coming back to Mr. Mistry, it is assumed that he is in the 30% bracket. (These figures are for ease of understanding and computations, in reality, the numbers would differ depending upon the interest rates in the economy. However, the principle would remain the same.)
The premise of the calculation is one’s own funds are freed up to the extent of the loan taken. In other words, if Mr. Mistry were to take a loan of Rs. 20 lakhs, it basically means that his personal funds to the extent of Rs. 20 lakh are available to be invested elsewhere which otherwise would not have been. The comparison is done based on these figures. Now look at the Table. Its essentially in two parts. The first part deals with the loan cashflows whereas the second part is regarding Mr. Mistry’s personal cashflows including that from investment.
It is assumed that the loan availed of is Rs. 20 lakh. The term is for 15 years. At an interest rate of 9% p.a., the EMI works out to Rs. 2,48,118. For simplicity, annual figures are taken. In actual practice, EMIs are paid monthly. The total interest paid out for the first year is Rs. 1,80,000. The closing balance for the first year is Rs. 20 lakhs less the capital repaid during the year.
Now coming to the second part of the table. As already discussed, since a loan of Rs. 20 lakhs is taken, Mr. Mistry can invest a similar amount of personal funds as he pleases. These funds (it is assumed) earn an pre-tax interest of 6.34% p.a. Therefore, the interest received for the first year would be Rs. 1,26,884.
What about the tax break on the EMIs? Taxes saved is money not paid i.e. it is money earned. Readers would know that housing loan interest is deductible to the extent of Rs. 1,50,000 per annum. Therefore, at a 30% tax rate, the advantage works out to Rs. 45,000 and so on. Similarly, the principal repayments are deductible under sec. 80C subject to the overall limit of Rs. 1,00,000. In the first year, Mr. Mistry repays capital to the extent of Rs. 68,118 and @30% the tax advantage is Rs. 20,435. The rest of the table is self explanatory.
Amount Rs. 2,000,000 ------Interest Rates-----
Loan Period 15 years On Loan 9.00% p.a
EMI (annual) Rs. 248,118 On Own Funds 6.34% p.a
Tax Zone 30%
Year Loan Taken Interest Capital Closing
Paid Repayment Balance
A B C D E=B-D
1 2,000,000 180,000 68,118 1,931,882
2 1,931,882 173,869 74,248 1,857,634
3 1,857,634 167,187 80,931 1,776,703
4 1,776,703 159,903 88,214 1,688,489
5 1,688,489 151,964 96,154 1,592,335
6 1,592,335 143,310 104,808 1,487,527
7 1,487,527 133,877 114,240 1,373,287
8 1,373,287 123,596 124,522 1,248,765
9 1,248,765 112,389 135,729 1,113,036
10 1,113,036 100,173 147,945 965,092
11 965,092 86,858 161,260 803,832
12 803,832 72,345 175,773 628,059
13 628,059 56,525 191,592 436,467
14 436,467 39,282 208,836 227,631
15 227,631 20,487 227,631 0
Own Funds Interest Tax Tax Tax Closing
Received Paid Saved Saved Balance
F G on I on P
2,000,000 126,844 38,053 45,000 20,435 1,906,109
1,906,109 120,890 36,267 45,000 22,275 1,809,888
1,809,888 114,787 34,436 45,000 24,279 1,711,400
1,711,400 108,541 32,562 45,000 26,464 1,610,725
1,610,725 102,156 30,647 45,000 28,846 1,507,963
1,507,963 95,638 28,691 42,993 30,000 1,399,785
1,399,785 88,777 26,633 40,163 30,000 1,283,974
1,283,974 81,432 24,430 37,079 30,000 1,159,938
1,159,938 73,566 22,070 33,717 30,000 1,027,033
1,027,033 65,137 19,541 30,052 30,000 884,563
884,563 56,101 16,830 26,057 30,000 731,773
731,773 46,411 13,923 21,703 30,000 567,846
567,846 36,014 10,804 16,958 30,000 391,896
391,896 24,855 7,456 11,785 30,000 202,961
202,961 12,872 3,862 6,146 30,000 0
The last column of the table is basically Mr. Mistry’s personal cashflow. The inflows are the interest earned and the tax saving on the interest and principal paid, whereas the outflows are the interest paid itself as well as the capital repayment.
In other words, because Mr. Mistry has taken the loan, his capital that he would have otherwise used for buying the house can earn some interest over the 15 year period. Similarly, all throughout, he will also get tax breaks on interest and principal. On the flip side, he will pay EMIs for the 15 years. Now, if after accounting for the above inflows and outflows, over 15 years, if Mr. Mistry were to end up with a zero balance, he would be indifferent to buying the house outright now or taking a loan. But if he were to end up having a positive bank balance, then he should take the loan and vice versa.
The above table throws up this indifference point. Putting it differently, were Mr. Mistry able to earn just 6.34% p.a. pre tax from his funds, it would make no difference to him whether he uses his own money for the property or whether he takes a loan. In other words, the break-even point in this case is 6.34% p.a.
What if instead of 6.34%, Mr. Mistry were able to earn 8% p.a. on his funds? Then it behooves him to go in for the loan by all means. If the revised numbers are plugged in the spreadsheet, one finds that Mr. Mistry would benefit by about Rs. 3.50 lakhs by opting for the loan.
Conversely, what if he were able to earn just 3% p.a.? In this case, by taking a loan, he would lose around Rs. 5.14 lakhs. So you see, this is a very powerful tool for every potential homeowner to determine the extent he should leverage himself.
Mr. Mistry happened to be in the 30% tax zone. If he were in the 20% tax zone, he would need to earn 7.51% p.a. and if he were in the 10% tax zone, his funds would need to earn 8.36% p.a. to break-even.
Basically, what these calculations throw up is nothing new. It is just restating the obvious but in terms of cold numbers. The greatest advantage of taking a loan emanates out of the tax breaks. It is in the interest of the investor to maximise these tax breaks. Using own funds results in foregoing the tax advantage.
Also note that the ceiling of Rs. 1,50,000 on interest is only in the case of self-occupied property. In the case of let out property, there is no ceiling on the interest deduction i.e. full interest paid is deductible. In this case, obviously, taking a loan would be advantageous. There is no question of using one’s own funds.
To Sum
If you are not in a position to use your own resources, then by all means avail of a loan. Interest rates though on the upswing lately are still very attractive and there is no better time to avail of a housing loan than the present. But if you do have the wherewithal to fund your own house, then remember to carry out the above analysis first.
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