Don't let home loan tax you

Partial or full prepayment makes sense, but only in some cases.

When Jabalpur resident Mahavir Ojha received Rs 80 lakhs (Rs 8 million) from selling an ancestral property, he decided to part-pay his housing loan of Rs 50 lakhs (Rs 5 million).

However, when 42-year-old Ojha realised that the prepayment would reduce the tax benefits on interest and principal payments, he refrained himself.

Ojha had taken a 20-year loan eight years ago.

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Taxation

Section 24 (b) of the Income Tax Act allows a deduction of interest payment up to Rs 150,000 from taxable income for self-occupied properties.

Under Section 80C, principal payment up to Rs 100,000, inclusive of other investments, can be deducted from the income while calculating the tax liability.

You will not be allowed a higher deduction than the prescribed limit and so paying more (pre-payment) makes little sense.

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"That's why prepaying does not make sense. Annual tax benefits do not change. Also, there is a penalty for prepaying. Many banks and housing finance companies do not even allow part-prepayment, although it is cheaper than foreclosure," says C S Jain, head-retail banking, IDBI Bank.

But there is respite if the loan being serviced is for a second property which is deemed 'let out' or rented.

There is no limit on interest repayment for a second home loan. It is entirely tax-free. Again, this means prepayment may not make much sense as one will lose the benefits.

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When to prepay?

Yes, the sheer size of the loan amount makes you feel that getting rid of the loan as soon as possible makes sense.

But remember, it is a loan with an asset to back it up. And, most likely, the asset price is rising as well.

Bankers say there are increased enquiries about home loan prepayments. Before prepaying, make sure you are not overleveraged. Instead, use the money to retire high-cost debt.

If you have high-cost debt such as credit cards and personal loans, retire that first. You should have a contingency corpus -- at least three months' salary.

Besides, have some investments in liquid instruments for easy access in unforeseen circumstances. Prepay the housing loan only if you have a surplus minus your regular investments.

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Interest rate increase

"If the interest rate on your home loan is increased, you can opt for part-prepayment," says a senior public sector banker.

It will ensure that your outgo towards monthly instalments does not increase and disturb your monthly cash flow.

The other option is to refinance the loan at a low rate. But you will have to pay a switching charge.

For instance, Axis Bank charges Rs 5,000, or one per cent of the outstanding, whichever is higher, for switching from fixed to floating rates and vice versa.

But if you change the lender to one who is offering a cheaper loan, you may have to pay more -- penalty to the old lender and processing fee to the new one.

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Prepayment

Remember that prepayment of housing loans can be expensive as it attracts a penalty.

For example, HDFC Bank charges a foreclosure charge of two per cent on the outstanding amount.

Making partial prepayments is one way to save charges.

Most banks have zero charge for partial prepayment. HDFC Bank allows prepayment of up to 25 per cent of the outstanding free of cost.

But make all enquiries about the clause attached to partial prepayment, as it may vary from one bank to another.

Some banks stress on having up to 12 instalments to pay after the prepayment.

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10-15 years remaining

Most banks penalise, or do not allow prepaying, in the first three to five years of the loan. Prepayment beyond this period is free, provided you show it is being done from your own resources.

"Paying debt is always better at a certain point in time," says Shyamal Saxena, GM-retail, Standard Chartered Bank.

It is advisable to wait if you have age on your side, as you cannot claim tax benefits above Rs 150,000.

"If the number of earning years is few, you may be better off repaying the loan as early as possible," adds Saxena.

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5-8 years remaining

Towards the end of the loan tenure, you repay the principal amount that is a part of the Rs 1 lakh investment limit allowed under Section 80C.

"Only if you are not investing in any of the exempted instruments will you be able to make full use of the principal repayment exemption, which most borrowers are not able to. So, you may be better off finishing it early," says Saxena.

Last 3 years

Don't bother. You are anyway servicing the principal amount.