Avantika is relaxing on a beautiful rattan recliner that she recently purchased from an online furniture store at a hefty discount. Her lavish independent bungalow in the bustling city of Bangalore cost a fortune to buy. The thought of owning her own space—one that she can decorate and call her own—had been a long-term dream. A ‘home’ where she can build and nurture her family, one where her children could grow up, making memories to last a lifetime. Her high-paying job allows her the freedom and flexibility to meet her payment obligations in the form of EMIs. Additionally, a recent ancestral division has provided her with the financial capability to foreclose her home loan, although a major portion of it remains to be paid.
But what is foreclosure of a loan? How does it work? And does it make financial sense to foreclose a loan? Would she be better off continuing to pay her EMIs and invest the additional money in the market? These questions weighed heavily on Avantika’s mind.
What is Foreclosure of a Home Loan?
A home loan is usually repaid to the bank in preset instalments as agreed between the lender and the buyer. Better known as EMIs or Equated Monthly Instalments, the amount is paid on a specified date each month. The EMI includes both the principal loan amount and the interest accrued over the loan tenure.
Foreclosure is simply the closing of a home loan by paying off the entire borrowed amount in one lump sum. It is part of the regular home loan process and allows you to pay off the borrowed amount before the EMI schedule.
Does Foreclosure Make Financial Sense?
There are multiple factors to consider here, and there is no one-size-fits-all solution. So, let’s try to break it down step by step.
- Is the Loan a Stress Factor? Many investors find loans stressful, to the point where some prefer never to take one. Money and related matters can impact an investor’s psyche and have lasting effects on their mental and physical well-being. In such cases, foreclosing a loan, if you have one, is a good option.
- The Interest Rate Factor: Housing loans offered by various banks and financial institutions generally have lower interest rates compared to other loans, albeit with longer tenures. Consider this—if you have a loan that charges a higher interest rate, it would be better to prioritize foreclosing that one first.
- The Tax Factor: A home loan allows you to claim certain deductions under Sections 80C & 24 for principal and interest payments and is particularly tax efficient under the old tax regime. Foreclosing the loan ahead of its tenure would mean losing out on these benefits. However, the deductions are limited to INR 1.5 lakhs for principal under Section 80C and INR 2 lakhs for interest under Section 24, if the house is self-occupied.
What Are the Options?
Foreclosing a loan is one option. Other strategies that a homeowner could consider include increasing the EMI or reducing the tenure as alternatives to foreclosure. When doing so, it’s important to consider the present value of money versus what it will be, say, 15 years down the line. What might seem like an expensive EMI today could convert into a much smaller amount, depending on the interest rate and inflation. Here, it becomes crucial to take into account multiple factors such as the age and remaining employment duration of the buyer, as well as any tax implications and additional benefits.
What If…
What if we said that a home loan could be made interest-free? A home loan could cost the buyer a major portion of their savings—possibly an arm and a leg too. Here’s how:
Home loan details:
For a home worth 75 lakhs, the buyer ends up making a down payment of 15 lakhs and paying a total interest of about 65 lakhs, essentially making the home 1.8 times costlier. Here are a few interesting statistics regarding home loans:
- A home buyer essentially pays more interest than the principal amount during the loan tenure.
- Interest is repaid first, meaning that over the loan tenure, your interest component will decrease while your principal amount will increase.
Making Loans Interest-Free:
Here’s a scenario where a home buyer simultaneously starts an SIP in a Mutual Fund equivalent to 0.10% of the home loan. From the above example, 0.10% amounts to INR 6,000 per month. Assuming a 13% return, the total value of this SIP investment would grow to INR 68,73,115 at the end of the 20th year. Let’s take this example even further by assuming that a buyer invests 0.35% of the home loan, amounting to INR 21,000. Assuming the same 13% return, the value of the SIP investment would grow to a whopping INR 2,40,55,902 by the end of the 20th years. These two scenarios are detailed in the table below:
By the end of the 20th year, the home buyer would have earned more than what is due as their total interest component on the home loan. In the above example, an excess of INR 3,76,459 in Scenario I and INR 1,75,59,246 in Scenario II.
Many home buyers consider the additional SIP amount a burden or a mini-EMI, as it represents an additional monthly investment. However, it’s crucial to consider the bigger picture. This kind of investment can prove beneficial in the long run, yielding substantial benefits!
