Personal Finance: A Case For Home Loans

PERSONAL FINANCE: PAYMENT SYSTEMS
How I bought a house and beat the system...
..Or Confessions Of An Investing Novice

A numbers-heavy exercise on how you could take a loan, buy a house, and (legally) cheat the taxman. Phew!

By Dilip Maitra

I'm told by my editor that most of you probably know this. But being the sort who believes in idiot-proofing everything, I'm going to risk stating the obvious: ceterus paribus, if you have the money to buy a house, don't use it; opt for a loan, instead. If you already knew that, gentle reader, pass on. There is a surfeit of good reading in this wondrous periodical you hold in your hands. If you don't, or if you do and you'd like to know why, read on.

If there's a protagonist in this, it is the Government of India (GOI), courtesy the tax incentives that have been unveiled in the last two editions of the Union Budget. Thus, interest payments up to the amount of Rs 100,000 on housing loans can be deducted from the taxable income. And under Section 88, 20 per cent of the principal amount re-paid, up to a maximum of Rs 20,000 can be deducted from the income tax payable. The caveat: these benefits are available only to those individuals who have taken a housing loan on or after April 1, 1999, and propose to live in the house they have bought or intend to purchase.

It's a great time to borrow too. In case you hadn't noticed, lending rates are down (ICICI offers loans at 12.75 per cent), and lenders are willing to stretch the pay-back period to hitherto unheard of levels (ICICI, again, has a 30-year pay-back option).

If it's proof undeniable you seek...

If you are one of those individuals who refuse to accept a numerical argument without scratching around on a piece of paper-I am-here goes (and I hope you have some paper handy). It's always easy to relate to numbers when you can put a name to them, so, let's take the case of this guy called Ram who works in a bank. Ram's taxable income works out to Rs 2.90 lakh a year; his tax, to Rs 77,000 a year. Let's assume Ram decides to buy a house for Rs 10,00,000. Even the most generous of lenders will expect Ram to put up at least 20 per cent of the cost of the house up front. Given his compensation though, it would not be too difficult for him to find a lender for the remaining 80 per cent (or Rs 800,000).

Scratch around a bit on that scrap of paper in your hand assuming a loan duration of 10 years and you'll realise that the Equated Monthly Instalments (EMI) work out to Rs 12,164, and the Annual Instalment (AI) to Rs 145, 968. In the first few repayment years, the bulk of the AI will be constituted by the interest component of the loan (Rs 102,000 in the first year, for instance). Over time, this will decline and the principal component increase. Ergo, Ram can derive optimal tax benefits in the early years.

Crunch some more numbers (and don't forget to factor in the Section 88 benefit), and you'll realise that Ram will save as much as Rs 37,000 on tax in the first year. By the fifth year, when the interest and principal components of the AI are almost the same, this would have come down to Rs 28,721. Over five years, then, Ram will save as much as Rs 167,000. Put otherwise, the effective rate of interest on the loan works out to 7.30 per cent in the first year (9.30 in the fifth).

So, you think you've spotted the fundamental flaw...

I often do, only to realise that I've jumped the gun. Remember the starting words of the axiom at the beginning of this composition: ceterus paribus, if you have the money... Ram does and the reason we've restricted our time-horizon to five years has everything to do with what plans he has for that money. The best thing he can do is to invest the Rs 800,000 he has left over after making his down payment in the Post Office's National Savings Scheme (NSS). The benefits? The interest income is tax-free and the amount invested qualifies for the Section 88 benefit of the Income-Tax Act.

Over five years, the Rs 800,000 invested by Ram will become Rs 1,318,000 (an annual yield of 12.95 per cent). Ram can just use the interest component of Rs 518,000 to pay off the residual loan of Rs 516,000, buy himself a bottle of good Scotch for Rs 2,000, and raise a toast to his own ingenuity. Cheers!

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