What your banker may not tell you about Home Loans.

Posted by Anurag Mishra on May 12th, 2017

Rakesh, a senior manager at a leading technology firm, had been making regular EMI payments on his home loan for the past 5 years. After getting possession of his new house he decided to look up the amortization schedule of his home loan for tax purposes and realized that contrary to expectation, only a small portion of his house loan interest principal had actually been repaid, what he had been paying so far was mostly the interest accrued on the home loan he had taken. In case you have noticed something similar, but haven’t quite understood why, read on to know more.

The Front Loading Method

In case of home loan repayment (or rather any loan repayment), the borrower often starts paying off the interest first and then moves on to the principal loan amount. This repayment system is termed as the front loading method. This ensures that the lender profits in the long term as the loan principal remains intact for a large part of house loan interest tenure, so that the interest payable is higher for a longer time, which increases profitability for the bank. By front loading, the bank minimizes its risk of loan default during the early period of the home loan tenure and improves the overall chances of keeping its profitability intact. The following is an example of how front loading occurs in case of a home loan of Rs. 50 lakhs at 8.5% for 20 year tenure.

As you can see from the above example, the interest repayment takes centre stage during the initial years of the house loan interest repayment, while the principal portion starts getting paid off in earnest only at a later date.

Home Loan Interest Payout vs. The Principal

As mentioned earlier, the home loan principal amount was Rs. 50 lakhs. However, you might be quite surprised if your take a closer look at how much total interest is payable on your home loan over the 20 year loan tenure.

As you can see from the above, on a Rs. 50 lakhs home loan, the total interest payable at the end of the 20 year tenure is Rs. 54 lakhs. This amount will be much higher for home loans with longer tenures or higher interest rates. So though the Rs. 1.5 lakh tax exemption under Section 80C and the Rs. 2 lakh tax exemption offered under Section 24 B are quite beneficial, however paying the extra interest on the amount might not always be a good idea. So in the long run, taking advantage of RBI’s regulation for zero foreclosure charges on floating rate home loans might just be the better options.

The exception to this rule is in case you have investment options that exceed your current house loan interest rate. In such as situation, investing instead of pre-payment might just be the right option for you!

{Source: http://www.paisabazaar.com/home-loan/articles/13089-what-your-banker-may-not-tell-you-about-home-loans/}

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Anurag Mishra

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Anurag Mishra
Joined: December 13th, 2016
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