Summary of this article
Ideally a borrower’s EMI should not exceed 40 per cent of his monthly earnings.
If we have enough liquidity flow in hand even after saving for other financial goals, then it is ideal to foreclose the loan in the initial years of the loan tenure.
The trade-off between foreclosing the loan or investing the excess surplus for the long term has to be properly examined before taking the decision to foreclose the loan.
Homebuying has become relatively easy nowadays due to the multitude of feasible options available to homebuyers to realise their dream of owning a home. Home loans remain the most popular option, especially if one can afford to pay the regular equated monthly instalment (EMI). However, paying EMIs over a long tenure can prove to be a significant burden on the borrower. In fact, a major part of one’s earnings goes towards EMI payments throughout the loan tenure or till it is foreclosed.
This is why most industry experts suggest that a borrower’s EMI should ideally not exceed 40 per cent of his/her monthly earnings. If it exceeds that limit, then foreclosing the loan either in tranches or in full, depending upon one’s payment capacity, would be a better option. However, foreclosing the loan is suggested only if it doesn’t disrupt one’s financial cycle.
Here are a few things to keep in mind before foreclosing a home loan.
Avoid Early Closure Penalties
The Reserve Bank of India (RBI) had some time ago waived off the penalty charges on foreclosure of floating rate home loans, which can be hugely beneficial to borrowers wanting to foreclose such loans. However, most banks do not encourage foreclosing a loan within six months of borrowing. Even if there are banks who offer this option, they would actually charge you a high processing fee, too. Moreover, it does not make sense to take a loan if one is capable of closing it within months of borrowing. Therefore, if one has a lump sum amount, then it would be worthwhile to meticulously analyse where to park the same before foreclosing the home loan.
Factor In Tax Benefits
There are certain tax benefits available on a home loan. For instance, under Section 80C of the Income-tax Act, 1961, tax deduction up to Rs 1.50 lakh can be availed of for repayment of the principal amount, while under Section 24B, one can avail of tax deduction of up to Rs 2 lakh on the interest paid for a housing loan for a self-occupied home. However, one won’t be able to avail of these tax benefits if the loan is foreclosed.
Evaluate the Ripple Effect on Your Financial Priorities
Foreclosing a home loan could have an impact on other financial goals, too. Also, it is not advisable to divert funds from other goals just to foreclose a home loan. For instance, diverting one’s retirement savings to foreclose a loan may not be the right approach. It is important to demarcate one’s financial goals and save and invest accordingly.
Target Early Closure to Reduce Total Interest Outgo
If we have enough liquidity in hand even after saving for other financial goals, then it is ideal to foreclose the loan in the initial years of the loan tenure. In the initial years of the loan, a major portion of the EMI comprises the interest payable by the borrower, while the principal part remains less.
So, foreclosing the loan at the earliest will help the borrower to save the amount that is paid as interest to the bank. If someone decides to foreclose the loan towards the end of the loan tenure, then by that time one would have paid most of the interest and only the principal amount might be left. Hence, the earlier the loan is foreclosed, the more someone saves on interest.
Weigh Investment Gains Against Borrowing Costs
If a borrower has enough liquidity with them, then instead of foreclosing the loan, it is advisable to invest into a diversified portfolio consisting of various asset classes which may yield higher returns. However, it is ideal to clear the loan if someone is nearing one’s retirement or has sought an early retirement. The borrower should foreclose the loan only if the rate of return on investments is expected to be lower than the rate of interest being paid for the home loan.
Conclusion
Foreclosing a home loan does bring a respite from EMIs and gives the satisfaction of getting rid of a liability. It looks even more convenient when one has a lump sum amount available. However, the trade-off between foreclosing the loan and investing the surplus for the long term has to be properly examined before taking a final decision on foreclosure. Even a small amount that is paid towards the principal can reduce the interest amount paid to the bank, but it is also important to seize other investment opportunities and choose the better decision.
