Home loan or your own funds? Get your math right

If you want to buy a house, you can either take a loan or use your own funds. Now, which option would be more beneficial and to what extent would depend on four variables.

These are the amount of loan, interest rate payable on such a loan, the tenure of the loan and the interest that your own funds can generate.

Each of these figures is critical and will affect the analysis significantly. For example, the total amount of loan and the prevailing interest rate will obviously determine the estimated monthly instalment (EMI) and the tenure. Any change in the EMI will affect the tenure and any change in interest rates will affect the EMI.

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 so, how much. So basically, it is the interplay between these four variables that eventually leads us to the most optimal solution. 

For example, let’s say Vishal takes a housing loan of  Rs15 lakh for 15 years @12% per annum while his own funds generate a pre-tax rate of 10.5% p.a. Now, since Vishal is taking a loan of Rs15 lakh, it means that his personal funds to that extent are available to be invested elsewhere which otherwise would not have been possible. He earns 10.5% before tax on these funds. He is in the 30.9% (including cess) tax bracket. The after tax interest is available to him to fund his EMI.

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

Please consider the table appearing above. The EMI on the loan works out to Rs2,20,236 p.a. For simplicity, annual figures are taken. In actual practice, EMIs are paid monthly. The total interest paid out for the first year is Rs1,80,000. The closing balance for the first year is Rs15 lakh less the capital repaid during the year.

Now coming to the second part of the table. As already discussed, since a loan of Rs15 lakh is taken, Vishal can invest a similar amount of personal funds as he pleases. These funds — it is assumed — earn a before tax interest of 10.5% p.a. Therefore, the interest received for the first year would be Rs1,57,500. Remember, he has to pay tax on this interest. At 30.9%, this tax works out to Rs48,668. 

Because of the loan, Vishal would also be eligible for a tax break on EMIs. Tax saved on interest in the first year works out to Rs46,350. Similarly, the principal repayments are deductible under Sec. 80C subject to the overall limit of Rs1,00,000. In the first year, Vishal repays capital to the extent of Rs40,236, thereby giving him a tax advantage of Rs12,433. Reduce the EMI payable from these figures and Vishal is left with a net closing balance of Rs14.47 lakh at the end of the first year.

The calculations for the rest of the years are worked out on similar lines. At the end of 15 years, Vishal finds that he is the proud owner of not only a house but also a bank balance of Rs2,11,682. And remember, this is after funding the EMIs.

To put it differently, had Vishal not opted for the loan but  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 — is more beneficial for Vishal than applying his own funds.

Notice that I have used the words “on the above terms”. This is to reiterate a point made earlier. 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.

For example, let’s say the interest on the loan amount goes up to 13%. In such a case, by taking the loan, Vishal would lose around Rs71,000. On the other hand, if Vishal can earn higher than 10.5% on his own funds, he would be much better-off than before. So, depending on the numbers plugged in the spreadsheet, every potential homeowner can decide to what extent he should leverage himself.

The writer is director, Wonderland Consultants.He can be reached at sandeep.shanbhag@gmail.com