After two back-to- back rate hikes of 25 basis points (bps) each in June and August, the Reserve Bank of India (RBI) left its policy rate unchanged in its October review last week; the policy repo rate stands at 6.5% now. However, RBI has changed its policy stance from “neutral" to “calibrated tightening", meaning that the rates in the current rate cycle will either remain stable or move upwards. What this means is that rates are certain to go up, if not now, then some months down the line. 

Explaining the move in RBI’s stance from neutral to calibrated tightening, RBI governor Urjit Patel had said in the post policy press conference, “What this stance indicates very clearly is that going forward there are only two options in this rate cycle, either we increase the rates or we keep them steady. With a neutral stance, a cut was also on the table."

With rates expected to go up in the medium term, should you explore foreclosing your home loan fully or partially in case you have a surplus?

Rising rates

Ahead of the October monetary policy review, State Bank of India increased its marginal cost of funds-based lending rate by 5 bps across tenures . If you are an existing borrower of an MCLR-linked home loan from SBI, your applicable rate will get revised in the next reset cycle based on whether the loan is linked with 1-year or 6-month MCLR. Every loan has a reset clause, which specifies the period after which the prevailing interest rate can be changed. SBI is currently offering home loans of up to 30 lakh at an effective rate (MCLR plus spread) of 8.70% to 9% per annum. 

Other banks are expected to follow suit in their MCLR revision cycles. So new borrowers should get ready to pay more as interest rate. Existing borrowers should brace themselves to see their floating rates go higher, if they haven’t already moved up in the past few months.

Tax benefits reduce effective rate

Before you decide to foreclose your home loan, consider the tax benefits you get on repayment of interest and principal amount every year.

The Income Tax Act allows a deduction of up to 1.5 lakh under Section 80C for principal repayment of a home loan, and a deduction up to 2 lakh for interest paid under Section 24(b) of the Act. 

While you can claim tax benefit under Section 80C for various other things like contribution to Employees’ Provident Fund, insurance policies, children’s tuition fees and investments in equity-linked savings schemes, deduction under Section 24(b) is exclusively for interest paid on home loans. 

Back-of-the-envelope calculations show that for an interest rate of 9%, the effective rate you pay, taking into consideration the tax benefit on interest payment, comes to around 6.2%, if you are in the highest tax bracket of 31.2%. For those in the lower tax brackets, the effective rate of interest will be higher.

Compare this effective interest rate with the post-tax return that the surplus lying with you will yield and then decide on foreclosing the loan. 

But are tax benefits enough?

Financial planners suggest that you should not keep a home loan while you have the capacity to foreclose it just for the tax benefit alone. The tax saving can happen only if you pay the interest rate, which may amount to a much higher sum than what is saved as tax.

However, if you can maintain the repayment of the loan through EMIs and at the same time, invest the surplus that you have in long-term equity funds, the combination of the two can be beneficial. If the returns from the investment are higher than the interest outgo, it will turn out to be a net gain for you. Tax benefit becomes a secondary and incidental benefit in that case.

“If you can invest the additional funds that you have for long-term goals through equity funds, where you can get around 12% return over a long period, then comparing that with the interest rate of 8.5% or 9% (on the home loan) is better. The only advantage of keeping a home loan is if you can manage a better return by investing in equity funds or direct equity for a long time," said Melvin Joseph, a Sebi-registered investment adviser and founder of Finvin Financial Planners. 

Another option is to pre-pay the loan partially, in such a way that the tax benefit gets optimised. In other words, bring down your loan level to an extent where the interest outgo is up to 2 lakh, the maximum amount eligible for deduction. Invest the remaining surplus in long-term equity funds.

It’s best to take the help of an expert to figure out what exactly works for you.