Home Loan Tax Benefits – A Mirage or Reality

Home Loan Tax Benefits is one of the key reasons to avail home loan. In other words, it is a motivational factor to buy a property on home loan. In my opinion, it is more of a perception that may or may not be true always. This perception is so deep rooted in our minds that it has become a sort of universal truth. Whenever we decide to purchase a property through Home Loan, our friends and relatives remind us about the attached Home Loan Tax Benefits. The million dollar question is Have you did financial calculations on Home Loan Tax Benefits? Based on my experience i can say that in 99.99% cases, the answer is NO.

Types of Home Loan Borrowers

There are numerous types of Home Loan Borrowers. Based on my experience, i am dedicating this post to following four types of borrowers.

1. I do agree that Home Loan Tax Benefits reduce the overall cost of borrowing. The problem arises when you avail home loan just for the sake of tax benefits attached to it. In other words, Home Loan Tax Benefits is the primary reason to avail home loan. These borrowers are over obsessed with tax savings. Normally, the people in highest income tax bracket falls under this category.

2. These borrowers can easily very prepay or close home loan due to higher income level and savings. They keep dragging home loan to continue availing Home Loan Tax Benefits. They are under a serious misconception that their income tax planning is meticulous. It may or may not be true.

3. A misconception on dual benefits of investment cum Home Loan Tax Benefits. These borrowers are the darling of builders and banks. The property is bought solely for investment purpose. In more than 95% cases, it is not a financially wise decision to buy a property for investment through a loan. I discussed it in detail in my post, Avoid Property Investment through Home Loan.

4. As i keep highlighting in my posts that a borrower should increase EMI in the proportion of the annual increase in salary. Some people do not follow this rule. The reason being, fear to lose Home Loan Tax Benefits. The increase in Salary increase the overall tax outflow. Therefore, a borrower tends to continue with a home loan for a longer period. Though it is not true always. The increase in EMI reduces the interest outflow thus reduce the overall cost of the property.

Home Loan Tax Benefits – One Side of the Story

I receive a lot of queries on Home Loan Tax Benefit Deductions. The biggest problem is that we only look at one side of the story. As i shared earlier that sometimes we are over obsessed with the Home Loan Tax Benefits. Have you every wondered at what cost you are getting these tax benefits? The cost is Home Loan Interest.

Recently i was glad to go through a query of one of my readers, his query was related to Home Loan prepayment. He did thorough calculations and concluded that Home Loan Interest outweighs the Home Loan Tax Benefits. In other words, on a net basis, the interest outflow was higher compared to the tax savings. Therefore, it makes perfect sense to prepay the home loan. He sought my inputs on the same.

The point i am trying to make is that a borrower should calculate the net benefit instead of a gross benefit. The net benefit can be calculated by deducting absolute interest outflow from the absolute tax savings. Here i would like to clarify that some borrowers make a mistake of considering tax deduction availed as net tax savings. It is not the correct interpretation.

For example, I and my wife have a self-occupied property. We both are individually claiming 1.5L and 2L tax deduction on principal and interest component of Home Loan. Our net tax savings is not 7L as perceived in most of the cases i.e. 3L for principal and 4L for interest. Net tax savings will be actual tax saved because of this deduction. Primarily, it will depend on income tax bracket. Assuming i am in 30% tax bracket and my wife is in 20% tax bracket. Considering the tax bracket is not changed even after availing tax deduction. Therefore, roughly my net tax savings will be 1.08L and my wife will save approx 72k. The household net tax savings will be 1.8L. On the contrary, the interest outflow will be much higher. As the property is self-occupied therefore we don’t mind negative tax savings as we are saving rent. The savings in rental payout or loss of HRA benefits should also be considered for net tax savings.

The net tax savings depends on multiple factors. Thus, the decision to continue with Home Loan Tax Benefits or prepay/closure of home loan will also depend on these factors. Let’s check out all these factors in detail.

Home Loan Tax Benefits – Key Factors

1. Self Occupied or Let Out Property

One of the most crucial factor that impacts the Home Loan Tax Benefits. Prima facie, a borrower/s in the highest income tax slab and the property is let out/rented can claim max Home Loan Tax Benefits. In this case, 100% interest component can be claimed under Income from House Property. This is my personal observation and not a universal rule.

On the other hand, an individual borrower in highest income tax slab with self-occupied property is the biggest loser on the tax front. In such cases, the borrower is not aware that HRA component becomes taxable. In other words, if the property is self-occupied then the borrower cannot claim a tax deduction on House Rent Allowance. On the other hand, borrower saves rent in case of self-occupied property. Therefore, loss of tax benefits on HRA is partially/fully compensated by the rental savings. The net impact varies from case to case depending on the rent and HRA. The max tax deduction for the self-occupied property is limited to 1.5L for Principal and 2L for interest component.

2. Income Tax Slab

It’s a no-brainer that the people in highest income tax bracket gain max from Home Loan Tax Benefits. Though it is important to consider all the key factors shared in this post to conclude. Assuming in the 20% tax bracket if salary structure is flexible with very low HRA component. In this case, the working couple can save income tax on a net basis for the self-occupied property after adjusting rent savings. In other words, permutation and combination of all the key factors can throw some interesting results.

3. Interest Rate and Home Loan Tenure

The lower interest rate means less interest outflow but tax savings remains fixed in certain cases like self-occupied property. The exception is once the interest component breaches the threshold of 2L. Therefore, the low-interest rate is good news for borrowers on the tax front. It might be beneficial to continue with a home loan when interest rates are low. This is especially true for people in higher income tax bracket. This benefit is nullified to some extent if your home loan tenure is long.

Besides interest rate, home loan tenure is also a crucial factor. These days banks are pushing home loan tenure of 30 years. It means increased interest outflow. For longer tenure home loans the interest outflow is more than the Home Loan Tax Benefits in almost all the cases. Therefore depending on the prevailing interest rate and tenure, a borrower has to calculate whether it is beneficial to avail home loan only for tax savings purpose or not.

4. Joint Home Loan

In my posts, i suggested joint home loan only in case of a working couple i.e. both the borrowers are availing Home Loan Tax Benefits. It maximizes the tax savings especially in the case of self-occupied property. Even if the key consideration is not to save tax but if both husband and wife are claiming tax deductions, it reduces the overall cost of borrowing. In case, one of the spouses is in lower tax bracket then the proportion of EMI can be adjusted to claim max tax deduction on an overall basis. The objective is that the spouse in higher tax bracket should claim max tax deductions. In some cases, it is beneficial that one spouse should claim 100% tax deductions. Therefore, he/she can pay 100% EMI and claim 100% tax deduction. In other words, you need to fine tune proportion of EMI to claim max Home Loan Tax Benefits.

5. EMI vs Salary

I have discussed this point earlier in the post. At the time of the availing home loan, EMI is 40% to 50% of net take home salary. Over a period of time, with an increase in salary, the EMI as % of net take home salary decrease. As i always suggest my readers to increase the EMI with an increase in salary. Until unless there is a compelling reason to keep EMI low, you should increase EMI. This is important especially if the net tax savings is negative. The increase in EMI will reduce the interest outflow. The +ve net tax savings is the best possible scenario for any borrower. Alternatively, a borrower should thrive to reduce the quantum of -ve tax savings i.e. in case interest outflow is more than tax savings. In such cases, an increase in EMI may have a positive impact.

6. Stage of Home Loan

As we are aware that during initial years of home, the major proportion of Home Loan EMI constitutes interest component. On the other hand, during grey years of the home loan, the principal component forms the major portion of EMI. It is a catch 22 situation for a borrower. Both the Home Loan Tax Benefits and Interest outflow reduce drastically as the home loan is near closure. Therefore, the stage of home loan is a crucial factor to check whether net tax savings is +ve or -ve. For sure, the low-value home loan borrowers availing tax deduction u/s 80C are happy towards the end of home loan tenure as deduction u/s 80C increases. On the contrary, the borrowers relying on interest component u/s 24B for tax savings e.g. in the case property is let out, the loss is maximum during last few years of the home loan.

7. Lump Sum Prepayment

Normally we receive lump sum amount as an annual performance bonus or at the time of maturity of past investment. There is no confusion or dilemma if the family decides to spend the money on an international holiday or big ticket purchase. The confusion is only in case if there is a dilemma whether to invest or prepay the home loan. I covered this topic in my post Should i invest or Prepay Loan ?. It is beneficial to invest if the home loan interest rates are low and some other investment class is delivering higher returns compared to the home loan interest rate. In such cases, it makes financial sense to invest instead of home loan prepayment.

Any lump sum prepayment can upset your tax calculations. Typically, home loan tenure is reduced on prepayment. Therefore, the proportion of principal component increases in EMI. In other words, lump sum prepayment resets the stage of home loan. Thus, it will have the same impact as i shared in point no 6.

Summary: There is no Right or Wrong answer in the case of Home Loan Tax Benefits. It is a very complex calculation to arrive at a right conclusion. Moreover, the conclusion is dynamic in nature. The reason being most of the factors are variable in nature. For example, any change in interest rate or tax slab can turn the calculations upside down. It makes sense to undertake this exercise if you are availing home loan only with an objective to avail Home Loan Tax Benefits.

Alternatively, if you are aware that your home loan is not favorable for you on tax front then you should either try to reduce the interest outflow by prepayment or increase the EMI. As i shared, you can try to maximize Home Loan Tax Benefits by availing joint home loan in case of working couple. The best example is of one of my clients. She bought a property in Thane in Mumbai. She and her husband’s office is in South Mumbai (Nariman Point). To reduce the overall cost of borrowing and to maximize tax benefits they rented out their apartment in Thane. Currently, they are staying on rent in Sion. Wife is claiming HRA as she is in highest tax bracket and also declare loss from the let out property. This arrangement is very much feasible in big cities. They have a valid reason to stay on rent in the same city as they are staying near to their workplace. This arrangement might not be feasible in small towns. Also, the proportion of EMI is 65:35 in favor of wife to maximize Home Loan Tax Benefits. Therefore, optimization of Home Loan Tax Benefits is a complex process :).

Hope you liked the post.

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