Take a loan, don't drain savings

Take a loan, don't drain savings

This way you not only end up owning a house but also maintain a healthy bank balance for future needs

Sandeep Shanbhag /  February 26, 2012, 0:20 IST

When we plan to buy a house, most of us buy it on borrowed capital or loan. The option is to use your own funds if you have enough savings or have saved specifically for this goal. But, you may ask which of the two is better. While that is a difficult question to answer, it would largely depend on four variables. 

• The amount of loan you want to take 
• The interest rate you will have to repay on the loan 
• The tenure for which you have borrowed from the financial institution 
• And the interest that your own funds can generate

Each of the above mentioned figure is critical and will affect the analysis significantly. For instance, the total amount of loan and the prevailing interest rate will obviously determine the equated monthly instalments (EMI) you will have to pay and the loan tenure. Any change in the EMI will affect the loan tenure and the EMI immediately. Say you had taken a home loan in 2006-07 at 7-8 per cent, one you would be repaying at 13-14 per cent, today and you loan tenure (if you had taken a 20 year loan) would be 25-27 years.

 

At the same time, the return that your own funds can earn would in turn determine whether you should opt for a loan in the first place and if yes, how much. So, it is the interplay between these four variables that eventually leads us to the most optimal solution.

Vishal takes a housing loan of Rs 15 lakh for 15 years at the rate of 12 per cent a year, while his own funds generate a pre-tax rate of 10.5 per cent yearly. Now, since Vishal is taking a loan of Rs 15 lakh, it means his personal funds to that extent are available to be invested elsewhere which otherwise would not have happened. He falls in the 30.9 per cent tax bracket. The post tax interest is available to him to fund the EMI.

Basically, the analysis throws up whether Vishal should buy the house using his own funds or whether it would be better to invest his funds and use the interest from such investment to pay the EMI.

Taking the table into consideration, you will have to go through a bit of number crunching, and if you stay with it, the results will be interesting. So let’s get started.

The EMI on the loan is around Rs 2.20 lakh annually. Taking annual figures for simplicity, otherwise, EMIs are paid monthly. The total interest paid out for the first year is Rs 1.8 lakh. The closing balance for the first year is Rs 15 lakh less the capital repaid during the year.

Now coming to the second part of the table. As already discussed, since Vishal’s taken a loan of Rs 15 lakh he can invest a similar amount of personal funds as he pleases. Therefore, the interest received for the first year would be Rs 1.57 lakh. He has to pay tax on this interest at 30.9 per cent or Rs 48,668.

The loan would give tax breaks to Vishal. Tax saved on interest in the first year is Rs 46,350. Similarly, the principal repayments are deductible under Section 80C up to Rs 1 lakh. In the first year, Vishal repays capital to the extent of Rs 40,236 thereby giving him a tax advantage of Rs 12,433. Reduce the EMI payable from these figures and Vishal is left with a net closing balance of Rs 14.47 lakh.

The calculations for the rest of the years are worked out on similar lines as above and at the end of fifteen years, Vishal finds that he is the proud owner of not only a house but also a bank balance of Rs 2.11 lakh. And this, after the EMIs.

To put it differently, had Vishal not opted for the loan but instead chosen to apply his own funds in the beginning itself, he would have ended up with only the house instead of a bank balance and the house. Therefore, opting for the loan (on the above terms) has worked in favour of Vishal. I reiterate ‘on the above terms’.

In the spreadsheet analysing Vishal’s loan, the variables were the loan amount, the tenure, the interest rate on the loan and also the interest rate earned on personal equity. Any variation in any of these variables may alter the conclusion materially.

THE MATH
Year	Amount borrowed	Interest repayment	Principal repayment	Own funds	Post- tax  interest	Total tax saved on loan	Closing balance
A	B	C	D	E	F	G	H = E + F + G - EMI
1	1,500,000	180,000	40,236	1,500,000	108,832	58,783	1,447,379
2	1,459,764	175,172	45,065	1,447,379	105,015	60,275	1,392,432
3	1,414,699	169,764	50,472	1,392,432	101,028	61,946	1,335,170
4	1,364,226	163,707	56,529	1,335,170	96,873	63,818	1,275,624
5	1,307,697	156,924	63,313	1,275,624	92,553	65,914	1,213,855
6	1,244,385	149,326	70,910	1,213,855	88,071	68,053	1,149,742
7	1,173,474	140,817	79,419	1,149,742	83,420	68,053	1,080,979
8	1,094,055	131,287	88,950	1,080,979	78,431	68,053	1,007,226
9	1,005,105	120,613	99,624	1,007,226	73,080	68,053	928,122
10	905,481	108,658	111,579	928,122	67,340	64,475	839,701
11	793,903	95,268	124,968	839,701	60,925	60,338	740,727
12	668,935	80,272	139,964	740,727	53,743	55,704	629,938
13	528,971	63,476	156,760	629,938	45,705	50,514