Wealth: Take a home loan or use own funds?

I am planning to buy a house sometime soon. I have enough funds to buy it outright. But would it make more sense to take a home loan considering the tax benefit?

The thumbrule:

Your decision to take a home loan will depend on whether your money will earn more interest than the interest you will spend on the loan. That is, if you take a loan at 11 per cent per annum, your savings should earn at least more than 11 per cent per annum. But it's not as simple as that. There are other factors like tax sops too.

So let’s make it simpler with this step-by-step guide. Let us assume that you go ahead and take the loan and invest the savings that you have in a bank fixed deposit (FD).

Step 1: Calculate your post tax interest income if investing in an FD

Let’s say, you have Rs 10 lakh, which you have decided to invest in a bank fixed deposit . It would earn you, say, a 7 per cent post tax return. This means you would make Rs 70,000 in the first year. Similarly, calculate the returns that you would get every year. The chart (refer to page 3) shows returns over a 20 year period. The total amount of funds accumulated over this time frame is approximately Rs 1.68 lakh.

Step 2: Calculate the total interest that you would have to pay on your home loan every year

For a loan of Rs 10 lakh at a fixed rate of 12 per cent, you would pay an interest of Rs 1.19 lakh in the first year (refer to page 3 ). This interest decreases with every year. At the end of 20 years, you would have paid an interest of Rs 16.43 lakh.

Step 3: Calculate the tax benefit you would receive on the interest paid on your home loan

In the above example, if you were in the 30 per cent tax bracket, you would save Rs 35,000 (30 per cent of Rs 1.19 lakh) as tax in the first year. Over 20 years, you would save Rs 4.92 lakh.

Step 4: Calculate the net benefit of taking a loan

Referring to the table, you would be paying interest of Rs 1.19 lakh in the first year but you would receive tax benefit of Rs 35,793. So your net payout would be Rs 83,207 in the first year. Over a 20 year period this would amount to Rs 11.5 lakh paid out as interest after accounting for the tax benefit received.

Note: Though in the initial years of repayment, the interest outflow on a yearly basis will be on the higher scale, in a reducing balance loan, this interest outflow will reduce and you will be repaying larger portions of the principal.

Step 5: Compare Step 1 and Step 4

By taking a loan and investing your savings, you stand to earn Rs 70,000 as interest. However, the net interest outflow on the loan would be Rs 83,207 even after adjusting the tax benefit in the first year. This means there is a greater outflow than inflow.

However, the key here is what happens with progress in time - the interest paid out in the first year will not be the same as the interest paid out in the previous yeas. From the calculations provided, you can see that even from the 3rd year onwards, the cash inflow is larger than the cash outflow.

So at the end of the 20 year loan, the interest accumulated on FD is Rs 28 lakh and the interest outgo on the home loan is Rs 11.5 lakh after adjusting the tax benefit.

What makes the difference:

The compounding interest you would receive if you park the funds in an FD is creating the huge difference. The total FD returns over a 20 year period would amount to Rs 28 lakh, which is a significant money inflow compared to the Rs 10 lakh loan that you need to take and pay an approximate total loan cost of Rs (10 + 9.6) lakh = 19.6 lakh.

If you have an appetite for risks and take the high risk option and invest in equities over a longer time frame, like the duration of the loan (15 to 20 years) you can expect a return of 15-17 per cent per annum. In both these instances, when you think long term instead of short term the scales seem to tilt in favour of taking the loan.