Budget 09 – Possible increase in home loan tax sop!

Now, you might assume that the equal parts of the principal and interest is repaid to the financial institution every month, however this not the case. During the initial years the interest component repaid is higher and during the latter years of repayment the principal component is higher. So, if you think you have paid half of the amount borrowed from the bank in 5 years in a 10 year loan tenure, that would not be the case. You would probably have reduced the total interest component due considerably and would have only repaid the interest component.

The government is trying to encourage lending to breath fresh life into the real estate and banking segments, which are currently coping and bouncing back from the effects of a realty market crash and global recession. One of the possible ways the government could opt to do this is by including a recommendation for increasing the tax slab for home loans in the upcoming budget announcement slated for the first week of July 2009.

This will be in the favour of the person opting for a new home loan. This will specifically be for the tax sop on the interest rate. Currently it is at 1.5 L and is likely to be increased to 3 L for the upcoming year.

The background

RBI has been trying to revive the lending scenario to try and keep the liquidity crunch at bay. RBI has cut its repo rate by 425 basis points and reverse repo rate by 275 basis points since September 2008. Responding to these cuts, PSBs and private banks too have responded with rate cuts.

Builders though very reluctant have started to bring down the property prices albeit at a very slow pace, which however does not match the consumer expectations. People are also very wary of new debt commitments at this point and the reluctance is obvious through the fact that in spite of the interest rate cuts in lending, people have not been very forthcoming towards taking new home loans. Probably there is a wait and watch approach being adopted to ensure that property prices will not drop beyond a point, to make the decision of a home purchase.

Understanding the interest component of your EMI

Let us analyze how this increased tax sop will be useful for the common man. For this, you need to understand how the concept of EMI works.

EMI, in other words an equated monthly installment (EMI) is the amount of money that is paid back to the lender on a monthly basis. It is essentially made up of two parts, the principal amount and the interest on the principal amount divided across each month in the loan tenure. The EMI is always paid up to the bank or lender on a fixed date each month until the total amount due is paid up during the tenure.

Now, you might assume that the equal parts of the principal and interest is repaid to the financial institution every month, however this not the case. During the initial years the interest component repaid is higher and during the latter years of repayment the principal component is higher. So, if you think you have paid half of the amount borrowed from the bank in 5 years in a 10 year loan tenure, that would not be the case. You would probably have reduced the total interest component due considerably and would have only repaid the interest component.

Here is an example that explains how the repayment of your EMI reduces your loan amount during the repayment period leading up to the end of the loan tenure.

In the example provided, the loan amount taken is Rs. 20 L, which is lent at a interest rate of say around 12%, over a loan tenure of 20 years (240 months).

The monthly EMI is calculated at the annualized rate of 12% and amounts to Rs.22,022 per month with the total interest component amounting to Rs.32.8 L.

You will notice from the example provided that the interest repaid decreases with each passing month starting at Rs. 20,000 from the first month and the principal repaid increases with each passing month starting from Rs.2,022 from the first month. This means that the interest component will be the greater portion of the EMI, which will reduce leading up towards the end of the loan tenure, while the reverse is true for the principal component.

How will the possible tax sop help?

Taking into account the fact that the interest outgo of your home loan will be the highest in the initial years of your home loan repayment, this tax sop will be highly useful for salaried individuals looking to obtain a home loan in the upcoming months. Apart from allocating a portion of money towards the EMI for the loan repayment, balance other budgetary needs like children’s education, household expenses, investment needs, medical expenses etc., a salaried individual also needs to pay a monthly tax outgo as well by way of TDS. The possibility of increasing the tax sop on the interest component of the EMI can now provide a welcome relief for people planning to take up a home loan as an additional sum of money can now be exempt from tax.

In the example provided it is clear that in the first five years there will definitely be a tax outgo that exceeds Rs. 2 L. In such a scenario, this increase in tax rebate will help with the higher interest outflow in the initial years.

Is the tax sop useful for existing home loan borrowers?

The tax sop covering the interest rate would certainly favour the new home loan borrower. However at this point when people are struggling to meet the existing loan commitments an increased tax rebate on the principal component would have greatly helped home loan borrowers who are in the middle of the their loan repayment. From the example provided it is also clear that home loan borrowers who are half way through their loan repayment or towards the end of their tenure might find an increased tax rebate on principal repaid highly useful.  Sources suggested this has been put on the table for discussion!

However, the attempt seems more focused towards encouraging a more active lending process, as that is seen as the need of the hour to bring back the realty market to its feet. Also, there is speculation amidst the potential home loan borrowers regarding how long these benefits such a interest rate cuts and tax sops will last, as home loans are long term commitments that last to the tune of 20-25 years. They feel once the markets show signs of improvement interest rates and property prices could see an upward swing, which will become a bottleneck for their monthly budget, a few years down the line.

This leads one to think that the real solution lies elsewhere. In this respect more affordable property prices and issues like job security will the the real key in turning around the markets and accelerating the pace of home purchases. Everything else seems to be falling in place except for that aspect, which is not at the expected levels yet. Currently the scenario seems to indicate that only if that happens will things change dramatically in the lending scenario!