Owning a home of our own is a dream for many of us. With the current property prices, it becomes nearly impossible for anyone in their 20s or 30s to afford to buy a house (unless they’ve earned a huge inheritance or won a big lottery)! This is where home loans come to our aid. Banks provide home loans to finance for the house you wish to purchase, in return for interest.
Basic loan terms:
- Principal: This is the amount taken as loan from the bank.
- Tenure: The number of years the loan is taken for. Varies between 5 to 30 years.
- Interest: The additional amount that has to be paid to the bank along with the principal.
- Interest rate: The rate at which interest on the loan amount is calculated.
- EMI (equated monthly installment): This is the amount that you pay back to the bank monthly during the loan tenure. It comprises of principal and the interest components.
Should you invest in a home early on or wait?
A generation or more back, most people purchased/constructed houses only in their late 30s or 40s, whereas these days, many purchase their first homes in their mid to late twenties itself. There are advantages in doing this early.
- Lesser expenses (and more disposable income) when you are single as opposed to when you are married and/or have kids.
- Home loan EMI forces compulsory savings of this disposable income
- The savings are made on an appreciating asset – real estate prices keep increasing (in the long run) due to increase in demand with the increasing population. Compare this with spending your savings on a fancy car or electronic gadget – the price of these items goes down as soon as the item is bought from the shop.
- Property prices would go up with the passing years, but your EMI would remain relatively constant during the loan tenure.
- Save on rent (if you move into your purchased home), which can be utilized towards paying EMI. Paying rent does not contribute to asset gain, whereas the home loan EMIs contribute towards owning a house.
- Salary hikes due to inflation and career advancement will reduce the percentage of income contributed towards the EMI, hence reducing the burden as years go by.
- Tax benefits
- Satisfaction of having achieved a major life goal early on in life!
Once a loan is sanctioned, agreed upon and signed, the loan amount is paid directly to the seller, and you have to pay the amount with interest back to the bank monthly as EMIs. There may also be some administrative charges and processing fees levied (approximately 1% of the loan amount). The original property documents may be required by the bank as collateral security till the loan is closed. This means if you fail to repay the loan, the bank can claim rights to the property.
Lets look more into the details of how a home loan works.
The loan amount approved by the bank will be based on your repayment capacity (income after expenses, occupation, liabilities/credit score, stability of income), property approval status and the property price. You can check your maximum loan eligibility even before finalizing on a property in order to determine your house budget.
- Banks approve only up to 80-90% of the property’s market value, so you should have sufficient savings or made arrangements for the remaining amount.
- Generally, home loans are provided only after a minimum of 3 years of employment, which provides assurance of income stability to the bank.
Loan tenure depends on your income and your age. If you avail the loan at a younger age, you are eligible for longer tenures. If you apply for a loan at the age of 50, banks would likely not approve a 30-year loan, as your remaining working years would be less.
- The longer the tenure, the more the interest amount paid on the loan.
- Longer tenure implies smaller monthly EMIs (as the loaned amount is split over a longer duration), but the overall interest will still be higher than that of the same loan amount for shorter tenure with bigger EMIs.
Generally, there are 2 types of home loan interest rate models
- Fixed rate: The interest rate remains constant throughout the loan tenure. This means that there will not be any change in the EMI or the tenure of the loan (unless the loan is pre-closed or partly paid back during the tenure). Generally, the rate will be a little higher than the floating rate at the time of availing the loan and typically carry pre-payment penalty charges (charges for part payment or closing of the loan earlier than the agreed tenure). Usually, banks provide fixed rate only for a certain number of years after it is converted to floating rate.
- Floating rate: The interest rate varies when there are changes in the lending rate of the bank and this results in changes to the interest calculated on the loan. Whenever there is an increase or decrease in the interest rate, the tenure increases or decreases. If there is an increase in the rate, it is advisable to increase your EMI (if affordable) to keep the tenure constant, rather than increasing the tenure of the loan. This will help bring down the overall interest payable, which increases as tenure increases.
Once you determine the loan amount, calculate how much you can comfortably afford to pay monthly as EMI. The banks will help you calculate the loan tenure based on this.
The maximum EMI approved by the bank will not be more than 65% of your monthly income.
If you can afford and wish to pay a higher EMI (either to reduce the interest payable or in order to avail a higher loan amount), you can apply for a joint loan along with your spouse, parent or sibling. The combined income of the applicants would be considered, resulting in eligibility for higher EMI.
Your EMI comprises of 2 components – the principal and the interest. One thing to understand is that although the EMI remains the same, the ratio of these 2 components varies.
During the initial years, the interest component will be very high and the principal component would be less. Whereas towards the end of your loan tenure, the interest component would be minimal and principal component would be very high. This is a way for banks to maximize their profits (which is the interest) and securing it upfront. That is why in the initial years, you may feel that although you have paid a lot as EMIs, the outstanding principal amount to be paid back has not gone down much comparatively.
Loans can be partly prepaid (without any charges for floating rate loans) to reduce the loan tenure. The above illustration explains why it is more beneficial to make prepayments (part or full) towards the initial years of the loan tenure. The interest amount will be recalculated for the updated outstanding loan amount after part payment, and hence overall interest will come down. Towards the end of the loan tenure, you would have already paid off most of the interest and hence it wouldn’t add much financial benefit in paying off the remaining outstanding principal earlier than required.
Home loans provide tax benefits only after completion of the house. This means that you do not get tax benefits while the house is still under construction. There are tax benefits on both the principal and interest components of the EMI paid in a year.
The principal amount is covered under Section 80C – (maximum of 1.5 Lakhs including all other 80C investments). However, this is applicable only for self-occupied houses (unless you live in another city).
The interest component is covered under section 24 (maximum of 2 Lakhs).
Tax benefits on the interest paid during the construction period can be claimed in 5 equal installments from the year of completion.
Note: For joint loans, each applicant can avail these tax benefits separately, to avail maximum tax benefits.
Tips that help to make the most of your loans
- Save enough to pay for the initial 20% down payment of the property, stamp duty, registration charges, as well as funds for interiors and furnishing as required. (Home loan top-ups are available too for interiors or personal use)
- Find a property that is near completion or completed to avail tax benefits from the beginning, as well as save on rent
- Mention all sources of income to increase your loan eligibility.
- Compare the rates offered by different banks
- Compare the turnaround time and customer service provided by different banks
- Compare the interest rate trend and frequency of rate changes of different banks
- Keep the tenure as less as possible with EMI to the maximum you can afford comfortably
- Make pre-payments whenever you get incentives or have extra savings – pre-payments made in the initial years provide maximum benefit
- If new home loans are provided as lower interest rates than the existing rate on your home loan, consider a loan transfer to the lower rate, or negotiate with your bank to lower your interest rate
My personal experience with home loan
I applied for a home loan in my late twenties. As I already had a decent amount saved up, I could make a significant down payment on my house. The balance amount was taken as a home loan. I was able to make part pre-payments of 25% and 16% of the principal amount in the 2nd and 3rd year of the loan, which brought down the loan tenure by half. This significantly brought down the overall interest that I had to pay on my loan.
Also, I bought a house that was already in completed stage. So, I was able to move in soon after the interiors were done and this removed the burden of paying monthly rent. This also enabled me to start availing tax benefits on the principal and interest components of the EMI. The tax benefits and the savings on rent throughout the loan tenure more than justified the extra interest amount paid for my loan.
Disclaimer: The opinions expressed in this post are the personal views of the author. They do not necessarily reflect the views of Aweekinlife.com. Any omissions or errors are the author’s and A Week In Life does not assume any liability or responsibility for them.