In November 2005, Mrinalinidevi, a resident of south Calcutta, took a Rs 7-lakh house loan from a private sector bank. At an interest rate of 7.5 per cent, her monthly outgo on the loan, to be repaid in 10 years, worked out to Rs 8,310 .

Since then, interest rates have steadily moved up and Mrinalinidevi is now paying an EMI (equated monthly instalment) of Rs 9,467 on the same loan at an annual interest rate of 11.75 per cent.

In these three years, she could repay only 18 per cent of her borrowed principal — the rest went into paying the interest on the loan.

Come December, home loans, both new and existing, are set to get cheaper. Public sector banks have already announced a 50-75-basis-point (one percentage point is equal to hundred basis points) cut in their prime lending rates. This means that interest rates on all loans that are linked to a bank’s benchmark prime lending rate (BPLR) will reduce to the same extent.

To a borrower, a drop in the interest rate of an existing home loan has two implications — the borrower can either opt for a reduction in EMI or shorten the repayment tenure of the home loan while paying the instalments at the existing rate.

Two-way option

A borrower’s option will depend on the current position of the repayment schedule. If you are halfway through the loan repayment tenure, you should keep on paying the EMI at the existing rate so that the number of outstanding instalments come down and the entire loan is repaid ahead of the deadline. If you are just three or four years into your repayment schedule of 20 years, opt for a lower EMI rather than shortening the loan tenure.

What’s the logic behind such a strategy?

The monthly instalment that one pays on a housing loan has two parts: one is interest and the other is the repayment of the principal amount.

In the beginning of the loan repayment schedule, a larger portion of the EMI is used up to pay interest and only a negligible portion of the principal is repaid. As the schedule progresses, the interest-principal mix changes so that towards the end the bulk of the EMI goes towards repaying the principal outstanding while the interest component gets reduced.

Tax twist

Now tax benefit on a housing loan also has two parts: while one can claim deduction under section 24 of the income tax act for interest payment, relief is available under section 80C of the act on the principal amount.

The maximum waiver available under section 24 is Rs 1.50 lakh, while section 80C allows deduction up to Rs 1 lakh on the principal.

As the interest component decreases during the later part of the repayment schedule, one can claim less deduction under section 24 of the income tax act for interest paid on a housing loan.

On the other hand, section 80C of the income tax — under which a home loan borrower can get tax relief for repaying the principal amount — allows deduction for various expenses and investments. Some of them are: life insurance premium, children’s tuition fees, contributions to provident fund, investments in National Savings Certificate, equity-linked savings schemes of mutual funds, tax-saving bank fixed deposits, Senior Citizen Savings Scheme and five-year post office fixed deposits.

If an individual has one or more of these expenses or investments, it is difficult for him/her to claim a greater deduction on higher repayment of home loan principal towards the end of the repayment schedule.

So, it is better to repay the loan faster if you cannot claim a higher tax benefit by lengthening the repayment period.

The situation is just the opposite if one is in the early stage of the repayment schedule when a larger part of the EMI goes towards interest.

So, till the time your EMI payments are skewed towards interest payment, it is advisable to continue with the repayment schedule and reap the benefit of tax deduction on interest payment as much as possible.

Advice for newbies

New home loan seekers, however, can wait for some more time. Public sector banks have announced a rate cut and their private sector peers are also expected to follow suit.

However, banks are reducing their lending rates not because their costs of deposits have come down.

The Reserve Bank of India has reduced the cash reserve ratio, a portion of their net deposits commercial banks are required to keep with the apex bank without earning any interest thereon.

Now, with the release of a portion of the reserve, banks can lend this extra liquidity and earn an interest in excess of 10 per cent. This is why banks are reducing their lending rates now.

One can, thus, expect another round of rate cut when the overall liquidity situation in the banking system improves and the banks’ cost of deposits decline.

Banks have already declared that they are considering slashing their peak deposit rate from 10.50 per cent to 10 per cent or below beginning December.

So, don’t hurry up and sign a home loan deal. Wait for the new year. You may also get a house at a lower price. Real estate prices in major cities have already started climbing down in the absence of sufficient demand. Besides, a lower rate of interest and, hence, a lower EMI will increase the maximum amount of home loan one is eligible for.

Banks determine a borrower’s loan eligibility by using the EMI to net monthly income ratio.

A salaried individual having a net annual income of Rs 5 lakh or more and having no other loan liability can pay up to 55 per cent of the net monthly income towards the housing loan EMI. Thus, if the rate of interest and, hence, the EMI goes down, the maximum loan one can get goes up, given the same income level.

A lot of calculation goes into making your dream home a reality. So, study the pros and cons before you decide to take the plunge.