While technology has altered the way loans are disbursed, the canons of prudent borrowing remain unchanged. It still doesn’t make sense to borrow if you don’t need the money. Or take a long-term loan only to enjoy the tax benefits available on the interest you pay. When calculating your allowable amount of debt, you need to know two terms:front-end ratio and back-end ratio.
A front end ratio indicates what portion of an individual’s income is used to make mortgage payments. It is calculated as an individual’s monthly housing expenses divided by his or her monthly gross income and is expressed as a percentage.
A back end ratio indicates what portion of a person’s monthly income goes toward paying debts. Total monthly debt includes expenses such as mortgage payments which include principal, interest, tax and Insurance credit-card payments, child support and other loan payments. Lenders use this ratio in conjunction with the front-end ratio to approve mortgages.
Also known as “debt-to-income ratio”
Your front-end ratio should never exceed 28 percent, and your back-end ratio needs to stay at or below 36 percent of gross monthly income.If you breach the front-end or back-end ratio, you’ll find yourself struggling to make ends meet. If you find that you’re already breaching one or both of these ratios, you need to start getting rid of some debt.
Home Loan – How much the banks will give and how much should you take?
This is what the loan providers consider a borrower should be like. Then they go on to offer you a loan up to max 80% of the total cost of buying the home. But the question is whether you can really afford to take all of it? How should you judiciously decide how much loan to take? There are no hard and fast rules. But, how much your home loan should cover depends on:
- your needs,
- future income potential and
- The ability to handle unexpected costs along the way.
Loan is a liability, so the wiser you are the better off you would be. One strategy is to go for a lower loan amount, lower than what you are eligible for. This will provide you with a headroom for diversification into other asset class and also monthly lower outgo towards EMI. This holds well with salaried class people. If possible also try to make a down payment of more than 20% because this will reduce your EMI.
Perhaps the best indicator that tells you how much your home loan should cover is your debt-to-income ratio as discussed above. In India, households often pay 25-40% of their income as EMIs. But, debt-to-income ratio should ideally be lower than 30%. If your household income is exceptionally high, you can afford to pay more.
Home loan or house rent – How to make the right choice?
The flowchart below may be able to help you decide. Like with most money questions, there’s no one, universal answer.Instead, it depends on your own situation. The following flowchart will give you an approximate answer just for now – if the chart says you’re better off renting, it certainly doesn’t mean you have to rent forever.In six months, a year, or even a matter of weeks, your situation could change and so could your answer.
Always consider the tax benefits that one can get if home loan is availed. In the long run paying rent becomes a costly affair.
Tax benefits on home loan in summary
|Tax Benefits||On Principal Repaid||On Interest Paid|
|First Home – Self Occupied||No change – Up toRs. One Lakh Fifty Thousand (Rs. Two Lakh for senior citizens)||No change – Up to Rs. Two Lakh if completed within 3 years from the end of the fin. year in which loan is taken, else Rs. 30,000|
|First Home – Rented/ Vacant||No change – Up toRs. One Lakh Fifty Thousand (Rs. Two Lakh for senior citizens) if staying in a different city for work||No change – On entire interest paid without any limit|
|Second Home||None||No change – On entire interest paid without any limit|
|Under Construction||None||No change – The interest paid can be claimed in equal parts in five financial years post completion or handing over.|
Loans – Should I avoid them altogether?
Not all loans are bad. If the loan is used to create an asset and is productive in nature, it can be termed as a good loan. Home, business and educational loans fall in this category.
On the other hand, if the loan creates no asset or is of very little productive use, it can be termed as a bad loan. A personal loan to go on a vacation or a heavy credit card swipe to buy an asset that would depreciate and an auto loan will fall in the bad loan category. They can create debt traps. Thus one should avoid taking such types of loans. By constantly educating oneself and by inculcating financial discipline one can successfully prevent falling into debt.
It is great if borrowing is avoided all together, but realistically almost everyone needs to borrow at some point in their lives. Be it individuals or enterprises. The major advantage of this being the tax benefits on many of the loans like housing, car and personal loan (for businesses) etc.
Have Surplus? Should I buy another home and pay EMI or invest?
Surplus here refers to the accumulated money you have after repaying all your debt. How to decide what to do with this money? Let’s look at the two options: buy another home or invest?
Go for buying another home (either in the same city or another city) if:
- You are pretty sure that you don’t need access to the surplus in future.(after making the down payment)
- You are certain that the city/place where you buy the house has reasonable scope for appreciation for your asset.(refer TOI article published on 14.12.2015 in personal finance section, to decide on the cities to buy homes)
- You are sure that you can handle the related expenses in the long run.
Thinking about investing, you need to decide on the types of investments:
- Short term (less than 5 years): Bank FDs, recurring deposits, NSCs etc. if you want some liquidity in near future.
- Medium term (5 – 10 years): medium term FDs, debt funds, debentures, balanced funds.
- Long term (above 10 years): retirement plans, life insurance, post office savings, PPF, bonds, equities.
Considering your financial situation, risk taking capacity and financial goals along with strategic planning can help you achieve what you aim for. Higher the risk higher would be the returns.
– Varsha Gaikwad.
Content writer – Dilzer Consultants Pvt. Ltd