Prepayment of home loan and applicable tax benefits

Most home owners began their home loan journey with a modest seven percent in the year 2003. Today, the interest rate hovers around 12 percent with most banks.

Now, if you have a huge loan, a long tenure ahead and some extra cash, should you prepay? Borrowers must analyze a variety of factors before jumping to a conclusion.

Here are some factors that must be taken into account:

Prepayment penalty:

Is there a penalty associated with prepayment? Some lenders are happy getting their money back sooner. Others charge a fixed percentage like two percent or allow you to repay some fixed amount every year without penalty. Evaluate the penalty and see if it is worth prepaying.
First pay off expensive loans:

If you have other higher interest commitments like car loan, personal loan or the more critical credit card debt, consider if it is feasible paying them off.

This is because home loan rates are supposed to be cheaper than these and additionally provide you with income tax benefits.

The more aggressive can explore investment options that yield returns greater than the home loan rate. If your excess money is coming from breaking such an investment, prepayment does not make sense. However, keep in mind that high return investments come with high risks.
While prepaying a loan entirely may be a prudent decision, prepaying small amounts of the loan can be attractive in the long run. In a home loan, as the years roll by, the interest component decreases and principal component goes up as a proportion of the EMI.

Some borrowers prefer not to prepay the loan after more than half the tenure has elapsed. Most borrowers are seen to repay their loans in eight years.

Are you close to retirement? If so, prepaying may be an excellent choice. In case the borrower fears that he will lose his job, it is better he repays his loan with the extra cash he has.

This ensures that unpaid EMIs due do not pile up and he doesn’t default. There will lesser pressure and some peace if he is without a job. It is better for new borrowers to opt for short home loan tenures. The EMIs will be huge, but you can pay off the loan faster.
Prepayment calculation:

Let us assume a person has purchased two houses for Rs 30 lakhs each, five years ago. He lives in one house and the other house has been rented out by him.

Let us consider the income tax implications on prepaying one of the two houses after five years.

When computing tax savings on the rented property, a rental income of Rs 8,000 per month is assumed. This amount is assumed to increase at a rate of five percent per annum. As much as 30 percent of the rental income can be deducted towards expenses incurred on periodic maintenance and property taxes.

Initial loan amount: Rs 30 lakhs Interest rate: 10 percent fixed.
Loan tenure: 15 years Years elapsed: 5 Years left: 10
Outstanding principal at the end of 5 years: Rs 24,39,500.
If the self-occupied property is prepaid, the net tax savings (combined for both the loans) for the years 6 to 15 is Rs 1,05,097.

If rented property is prepaid, net tax savings (combined for both the loans) for years 6 to 15 is Rs 3,26,470.

Hence, it is prudent to prepay the loan on the rented property, provided all factors and parameters are similar between the two home loans.
Tax deduction on the principal
Individuals can claim a tax deduction on the principal and interest components of a home loan as per the Income Tax Act 1961.

These deductions are available under Section 24(b) to assessees who have taken a loan to either buy or build a house.
In case these conditions are met, interest on borrowed capital is deductible up to Rs 1.5 lakhs:

Capital is borrowed on or after April 1, 1999 to acquire or construct a residential property The acquisition / construction should be completed within three years from the end of the financial year in which capital was borrowed.
The bank extending the loan certifies that the interest is payable on the amount advanced for acquisition or construction of the house, or as refinance of the principle amount outstanding under an earlier loan.

In case the conditions stated are not met, interest on borrowed capital is deductible up to Rs 30,000. However, the capital should have been borrowed before April 1, 1999 for the purchase, construction, or repairs of a house.
If the capital was borrowed on or after April 1, 1999, the construction should have been completed within three years from the end of the year in which the capital was borrowed.

In addition, principal repayment of the loan borrowed is eligible for a deduction of up to Rs 1 lakh under Section 80C from the assessment year 2006-07.
The maximum deduction permissible in a financial year for the original loan (if any) plus for any additional loans taken is Rs 1.5 lakhs.

Hence, if deduction on an existing loan is less than Rs 1.5 lakhs, you can claim further benefits from an additional loan, subject to an upper limit of Rs 1.5 lakhs in a financial year.
It is to be noted that the tax benefits under Section 24 and deductions under Section 80C of the Income Tax Act can be claimed only when the payment is made.

If a person fails to make EMI payments, he cannot claim tax benefits on them. Under the Income Tax Act, only the person who has taken the loan can claim tax rebates. Interest on a fresh loan can be claimed as a deduction, subject to the upper limit.

The interest on a loan, taken for repairs, renewals or reconstruction, also qualifies for the deduction of Rs 1.5 lakhs. If husband and wife, both are taxpayers with independent income sources, can get tax deductions on the same housing loan. In this case, the tax benefits can be shared to the extent of the amount of loan taken in their names.

If it is proved that a home loan is simply an arrangement between a loan-seeker and a builder or with a third party for the purpose of claiming tax benefits, the tax benefits will not be allowed and benefits previously claimed will be clubbed to the income and taxed accordingly.