So I have this friend, who, purchased a house worth 1.5 crs, a year ago, and for the same, took a loan of 1.2 crs. He worked for an MNC and getting the loan, was not difficult, since his wife too was earning well.
We met a month ago, and he was proudly showing off that his house is now worth 1.7 crs already, due to appreciation over the last one year, therby making a neat 20 lacs in profit.
He must have calculated his profit by subtracting the current value of his property, less the cost of the house (as per him it was 1.5 crs). I think he was wrong.
I am not going into the details of property tax, wear and tear, and other technical aspects to calculate the real profit but a major loophole in his calculation, which all of us, tend to make, is with respect to the cost of the house which was purchased with a housing loan.
The biggest problem with most of us is that we don’t really know how much money we have to pay the bank when ones takes a housing loan. The only information, my friend probably knew, was that he is taking a 1.2 crs home loan on 10.5% interest rate for a period of 20 years.
What he should have known is that he would be paying back 2.8 crs to the bank over the next 20 years. (Assuming he does not pre pay his loan). This is the total cost of his loan, 1.2 crs which he borrowed for funding his hose and rest 1.6 crs he would have to payback as interest cost.
I am sure to a few of the readers this would be an eye opener.
Now if you know this information, you will realize that you haven’t made any profit if the flat cost has gone 10%, since the real cost is 2.8 crs ( and much more if you were to include maintenance , taxes, parking fees and other stuff) compared to the value of the property – 1.7 crs.
Of course the point of argument would be that he anyways wanted to buy a flat so this information would not make him change his mind.
But yes if one were to consider property as an investment this information is very crucial to really understand whether it’s worth investing in one.
BUT I GET TAX DEDCUATIONS FROM HOUSING LOAN
Agreed. This is a whole new topic altogether to discuss and I don’t want to elaborate on this since it would make this blog too lengthy and technical. But the point is overall the benefit you get from tax deductions may be a small part compared to the interest cost you are paying for the loan.
HOW CAN WE REDUCE OUR REPAYMENT BURDEN
This blog does not aim at dissuading one from taking a home loan but only to make one aware of the
1) Real cost of taking a home loan – So that you know, what you are getting into. Once you know the real loan cost, at least you will have a clear idea how much are you repaying and is the house expensive or cheaper.
2) Steps to minimize the interest cost, which is the main culprit in any loan: Imagine, you have to pay 1.3 crs additional, for taking a 1.5 crs loan? Doesn’t it sound too much? Maybe you can’t do anything about it. You need to buy a house and you have to pay interest, but can you minimize the cost by doing few things smartly. That is the intention of this blog.
So now since interest is the real villain, how do you reduce the same?
In a home loan there are only two ways to reduce the interest cost
1) Reduce the interest rate
2) Reduce the tenure since the longer you take to repay the more interest you need to pay.
Since interest rates are decided by external forces you can’t do much about it. Go for the bank which offers the most competitive interest rates (some other points have to be noted, which are mentioned at the end of this blog)
However, you can really save some money, by understanding the importance of tenure period. You can reduce the interest cost, by modifying the tenure period at the time of taking loan, and during repayments.
Opt for a shorter tenure as possible
Why is this important
If you can afford the monthly EMI, the shorter the tenure, the lower is the interest cost, and lower you have to repay. Thus saving on interest cost.
So if my friend, who took a 1.2 crs loan, at 10.5% interest cost, would have gone for 15 years tenure, instead of 20, it would have cost him 2.3 crs as against the existing 2.8 crs. 50 lacs, in lesser pay out.
Of course, goes without saying, you should be able to afford the EMI for the shorter tenure, since it’s higher than EMI for a longer period. But remember, more the time taken to repay the more is the interest cost!
Whenever you are pre paying – use it to reduce the tenure
When you have a windfall receipt like bonus, or some salary raise and you can afford to prepay part of your loan. The banks generally provide you two options – Reduce the monthly EMI and keep the same tenure or Keep the same EMI and reduce the tenure
Most people make the mistake of reducing the EMI. Never ever do that. By doing this even if you are prepaying, you don’t get any advantage, since the rate of interest and tenure remains the same. The amount is only adjusted against the principal and not the interest.
However, if you reduce the tenure, you are actually reducing the interest cost, since you would have to pay interest for lesser duration.
And finally some other important things while taking home loan.
Rate of interest is definitely important however these other factors are also crucial and should be considered
- Pre-Payment Penalty Clause. If you were to pre pay the home loan are there any charges being deducted. These lesser this is, the better.
- Processing Fees
- Ideally you should avoid any loans!
- If you have to take a loan do calculate the total cost of the loan over the tenure. Principal and Interest Cost together. Just by doing this you would be more prudent in your decision.
- Try to take shorter tenure and work hard to repay it
- Whenever you have a windfall gain or some extra money use it to pre pay the loan
- If you have more than one loan, prepay that which has the highest interest outgo.