Wednesday, October 26, 2011

Pre-pay my Housing & Education Loan?

My friend Sandeep and I were having lunch today when the news flashed across the screen – ‘RBI has hiked interest rates again by 25bps’. With the central bank hiking the interest rates every few months, loans were getting costlier and our salaries were not increasing at that rate! After seeing this news we got into a discussion as to whether it made sense to pre-close the education loan that he had or should he not pre-close it since he was receiving tax benefits. This is a question a lot of people ask, especially among those who have a housing loan since housing loans give higher tax breaks. This article seeks to demystify this confusion among several people as to whether it makes sense to pre-close a loan if they come into some additional money.


Education Loan:
Assume that a certain person has taken Rs 10,00,000 as education loan at 13% average interest rate for a period of 60 months. His monthly EMI comes to Rs 22,753. Now this person also gets a gift of Rs 10,00,000 from his dad and now has the option of pre-closing his loan. Now consider that he chooses not to pre-close his loan and instead pay EMIs, save tax and earn a fixed deposit (term deposit) interest of 8.5% for 60 months of his loan tenure.
Lets also assume that this person earns around Rs 7,00,000 per annum. For an education loan, the interest can be deducted under section 80C which gives this person a tax relief of Rs 14,607 annually.
PRINCIPAL = 10,00,000
Rate = 13%
Term = 60 months
EMI = 22753
Interest part = 6086
Principal Part = 16,667
Tax Saved annually: 14,607
Interest Earned in FD for 60 months: 5,27,300
Total Tax Savings & Interest earned in 5 years: 6,00,335
Difference between Earnings & Interest Paid out = 2,35,155
As shown in the above table, it makes more sense for a person who gets a windfall amount to start a Fixed Deposit, rather than pay off his loan.
Housing Loans:
Let’s assume that a certain person takes Rs 20,00,000 as housing loan at 11% average interest rate for a period of 120 months. His monthly EMI comes to Rs 27,550. Now this person also gets Rs 20,00,000 as inheritance from a rich uncle and now has the option of pre-closing his loan. Consider that he chooses not to pre-close his loan and instead pay EMIs, save tax and earn a fixed deposit (term deposit) interest of 7.5% for 120 months of his loan tenure.
Lets also assume that this person earns around Rs 7,00,000 per annum. For housing loans, the principal can be deducted under section 80C up to Rs 1,00,000 and interest deduction from gross pay up to Rs 1,50,000 which gives this person a tax relief of Rs 46,000 annually.
PRINCIPAL = 20,00,000
Rate = 11%
Term = 120 months
EMI = 27550
Interest part = 10884
Principal Part = 16,666
Tax Saved annually: 46,000
Interest Earned in FD for 120 months: 22,24,129
Total Tax Savings & Interest earned in 10 years: 26,84,129
Difference between Earnings & Interest Paid out = 13,78,049
Once again it makes tremendous sense for a person to keep the entire money in an FD for 10 years rather than pre-close his/her loan.
Disclaimer: I have not calculated the tax on the interest from an FD (currently at 10.33% per annum) to simplify the calculations.
Though the numbers talk all this, there is no way you can quantify the peace of mind that a debt-free life gives. There are some things that money can’t buy and the peace of mind in being debt-free is truly priceless!

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