Nikhil Walavalkar Moneycontrol News
Loans become part of one's financial matters when one can’t meet their aspirations with their current income or due to unforeseen emergencies such as hospitalisation. Personal loans help to achieve smaller goals such as financing marriages, vacations and smaller expenses.
On the other hand, high home prices makes home loan an essential while buying a property. Many borrowers us end up opting for both: personal as well as a home loan. As income increases over time or when one receives a one-time cash inflow, a borrower wonders which one should be prepaid first. The emotional answer to this question is to ‘secure’ one’s home by paying off the loan. But for a logical, financial answer, one needs to take into considerations several factors:
Focus on the cost of loan
To turn debt free, one may choose to pay off the largest loan first or the smallest loan first, depending on one's view. In the financial world, the cost or interest rate payable on the loan is more important than size of the loan outstanding. “Target the high-cost loan first. Generally, home loans are cheaper than personal loans and hence the latter should be repaid first. Only exception would be employer provided subsidised personal loans where interest rates may be lower than home loans,” Ramalingam K, Chief Financial Planner at Holistic Investments, said.
Home loans nowadays start at 8.75 percent, but personal loans are costlier at 14 percent onwards. A repayment of Rs 1 lakh towards a loan of Rs 3 lakh, payable over three years, at 8.75 percent rate of interest will entail savings on interest to the tune of Rs 24000. But for the same loan, if the interest rate changes to 14 percent, then the saving will be around Rs 40,000, excluding charges. The numbers speak for themselves.
Tax benefits
Personal loans do not offer income tax benefits. Home loans, however, allow you a deduction up to Rs 1.5 lakh per year towards repayment of principal and up to Rs 2 lakh per year towards interest payment. “Tax benefits associated with home loans help reduce your income tax liability and hence can be repaid as per schedule by enjoying all the tax benefits,” Vinayak Savanur, Founder, MoneyMintingMantra, a financial planning firm, said.
If you decide to pre-pay personal loan partially or fully, then your tax planning is not affected at all as there are no tax benefits for personal loans availed. However, partial or full repayment of home loan may alter your tax planning for years.
Ancillary benefits like top-up loans, overdraft facilities
Plain vanilla home loans are history. Most big ticket home loans come bundled with an overdraft facility and top-up options. Some do offer a current account facility wherein you can park your surplus funds and save on interest. These facilities make a home loan ‘not so evil’ for many consumers, especially if you are self-employed. But personal loans do not offer any such additional benefits.
Though additional facilities come at a cost with a home loan, they are even costlier if bought separately. Hence, it makes sense to continue with your home loan in such cases. That makes a strong case for repayment of personal viz-a-viz a home loan.
Credit score
The black box that determines credit score of an individual has multiple factors. Experts feel the presence of secured loans such as a home loan is better for building a credit score than unsecured loans like a personal loan. Home loans let one create a long-term credit history that augurs well while building a credit score. Hence, it makes sense to pay off a personal loan first.
Prepayment penalties
This is a point where prepaying a personal loan seems pinching. Personal loans have heavy pre-payment penalties in the 3-4% range. Some lenders do not allow you to pre-repay a personal loan in the first six months. Even post that the pre-payment penalties are high. Floating rate home loans do not come with prepayment penalties. Fixed rate home loans may however come with pre-payment penalties.
Hence, while prepaying a personal loan one will have to account for the additional burden of penalties. Given the various benefits mentioned above it makes sense to close your personal loan first.
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