A N Shanbhag: Live on borrowed time

Every housebuyer should take a loan because of the tax advantages

If you want to buy a house, you have two options. Either take a loan or use your own funds. Most of us obviously can't afford an outright purchase (without availing of any loan whatsoever).

However, even those fortunate few who have the wherewithal to buy a house with their own cash should avail of a loan. Let us see why.

Well, for starters interest outgo on loans of up to Rs 150,000 is tax deductible. Moreover, the capital repayments are eligible for Section 88 rebate up to Rs 20,000 within the overall general limit of Rs 70,000.

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 to buy the house? If you do, 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 the 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 who is in the 30 per cent tax zone, has taken a housing loan of Rs 18 lakh at 8 per cent p.a., whereas his own funds of an equal amount have been invested in RBI 6.5 per cent tax-free bonds.

He pays an interest of Rs 144,000 for the first year and saves tax of Rs 43,200. He also earns Rs 117,000 on his Savings Bonds. Thus he pays Rs 144,000 as interest and earns Rs 160,200 (= 43,200 + 117,000) by way of tax-free interest and savings in tax.

He makes a cool profit of Rs 26,200 in the process. And this analysis does not take into account the benefit of Section 88 rebate.

This is a win-win situation for both the housing finance company as well as the borrower. Yes, such borrowers will never default. If there is a default, the company can repossess the house. Understandably, the non-performing assets of these companies have come down drastically making housing finance much more lucrative than car loans or loans for white goods.

Mr Mistry happened to be in the 30 per cent tax zone. If he were in the 20 per cent tax zone, he would still be a gainer, but the gain will be marginal.

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 break on interest. It is in the interest of the investor to maximise this tax break. Using own funds results in forgoing the tax advantage.

Also note that the ceiling of Rs 150,000 on interest is only in the case of self-occupied property. In the case of let out or commercial property, there is no ceiling on the interest deduction i.e. full interest paid is deductible.

Strategy Employed by Banks
Section 24 which allows deduction for "" "Where the property has been acquired, constructed, repaired, renewed or reconstructed with borrowed capital, the amount of any interest payable on such capital."

Note that the word used is 'payable' and not 'paid'. Therefore, if the finance company adjusts the entire amount of EMI towards the principal first and debits the interest to 'interest collectable' account, the borrower will derive the maximum tax benefit.

A certificate furnished to the borrower indicating the amount of interest payable gives him a handle to claim the rebate u/s 88 on a larger amount without losing deductibility u/s 24, even by an iota.

The actual interest payment can wait until the principal amount is collected. Some employers, especially PSUs and banks, follow this practice.

In such cases since the deduction of interest is already claimed on accrual basis one cannot claim it once again when the interest is actually being recovered.

I hope some of the financial institutions, especially more dynamic one like HDFC, take a lead in changing their structure of EMI. As a matter of fact, the housing companies will do well by giving the option to the borrower of choosing whether to i) treat the entire EMI as interest in the beginning or ii) treat it as repayment of the capital or iii) apply the normal reducing balance method!

To Sum
Understandably, there is a fierce competition amongst the housing finance companies which has brought the interest rates perhaps at their lowest, surely lower than 8 per cent. There is no better time to avail of a housing loan than the present.

If you are not in a position to use your own resources, then by all means avail of a loan.

The author may be contacted at
anshanbhag@yahoo.com