Should you opt for EMI or Pre-EMI for your Home Loan?
Updated on March 7, 20195 mins read
What is Pre-EMI?
Pre-EMIs are installments that precede actual EMIs.
Pay for What You Use
If you purchase a property under construction and finance it with a bank loan, the funds are most often released in tranches by the bank. The disbursement is based on the proportion of completion of the project. Consequently, till you obtain possession of the house, you are faced with an option to service just the disbursed portion of the loan, instead of the entire amount sanctioned.
This essentially means the borrower needs to pay only interest and only on the amount disbursed till he is handed over the house. The repayment of the principal component sets in once the entire loan amount is disbursed or the possession of the house is turned over to the borrower. This ‘payment of only interest on the amount disbursed’ is Pre-EMI.
EMI / Pre-EMI – The Choice is Yours
Pre-EMI is an option available to the borrower. He must base his decision on his personal requirements after considering the loan mathematics involved.
Let’s use an example to understand the basic difference between EMI and Pre-EMI:
The first step is to familiarize ourselves first with the mathematical formula to calculate EMI:
[P X r X (1+r)^n]/[(1+r)^n-1] P = Loan amount or principal r = Interest rate per month n = Number of total installments
Now we shall describe 2 scenarios: Scenario I describes EMI, i.e. when the bank disburses the entire loan in one go. Scenario II describes Pre-EMI, when the bank gives the loan in tranches.
SCENARIO I Banks Disburses the Entire Loan Amount
An EMI of Rs.24,365.50 becomes payable immediately. The Loan Amortization Schedule for the first 10 installments has been provided below:
Since the bank in this case has funded the entire loan upfront, the borrower must start paying the principal as well as the interest components immediately..
Banks Disburses the Loan Amount in Parts
Banks generally disburses loans in 3-6 tranches. However, for ease of understanding, we project a scenario with Rs.1,00,000 being disbursed every month for 2 years of construction period. The schedule would resemble the following:
This is a very basic projection of monthly interest of Rs. 896 per lakh.
What it translates to:
Monthly EMI – Rs.24,365.50 (derived from Scenario I) Monthly Average Pre-EMI – Rs.11,200 (Derived from Scenario II) Difference between EMI and Average Pre-EMI = Rs. 13,166
Savings in Pre-EMI as above projected for 2 years = Rs. 13,165.50 *24 = Rs. 3,15,972
Of course, the borrower has to pay the EMI once he gets the possession of the property. Hence, he would pay Rs.24,365.50 per month for additional 2 years (after the Pre-EMI period gets over) if he opts for Pre-EMI.
To understand the full picture, we need to consider the time value of money. The Rs.3,15,972 savings in the Pre-EMI option (from above) could lead to 10% annual return through long term, active or prudent investing. And the borrower could end up with a sum of Rs.21,25,700 approximately. So, after paying for 2 additional years at the end of the tenure, he would still have a good lump sum saved up.
What are the factors you need to evaluate before choosing the Pre-EMI option?
As is apparent, the borrower faces lower cash out-flows for the first 24-36 months through the Pre-EMI route. However, this also translates to longer repayment tenure. The funds saved now, would need to be justifiably invested. Pre-EMI is an option and available to borrowers and as such demands careful consideration. Besides, paying of a debt sooner may also be a personal choice despite the numbers.
Here are some basic questions to aid the decision making process:
Do you have the cash flow to start repaying your loan fully?
Do you plan to keep the house property or sell it during or immediately after the construction?
Do you expect to earn rental income from the property?
Very importantly – what is the opportunity cost of the money you are saving for the moment
Would you be able to invest the balance elsewhere and generate good returns?
Do you require the balance for some other urgent expenses for the time being?
When should you opt for Pre-EMI?
The Pre-EMI option is suitable for you in the following scenarios:
If you have lower cash flows available in the initial years
If you plan to sell your property in the first few years, perhaps even at the time of possession
If you can invest the difference between EMI and Pre-EMI in a manner that you generate returns higher than the rate of interest (10-12% every year in the case of our example)
If you require the balance for some very important immediate needs
When is it advised to opt for EMI instead of Pre-EMI?
If you are eager to start enjoying tax benefits of the property investment
If the property is a long term investment (to move in yourself or let out) and you would like it to be debt-free at the earliest.
If you expect delays in the completion of the project and do not wish to wait long to start principal repayment.
If active investment does not seem feasible
Additionally, based on the builder’s work in the past, you may also want to consider if he deserves to receive the entire loan amount at the start of a project or only based on his progress therein.
What is the Tax Angle on Pre-EMI?
Apart from the calculations, it is necessary to understand the tax angles on Pre-EMI.
Housing loan is governed by two sections of the Income Tax Act. The Section 80C, which we are all pretty familiar with and Section 24, which pertains specifically to Housing Property.
Any principal prepaid by an individual before obtaining ownership of a property, is not deductible under the Income Tax Act. This rules-out benefits under section 80C.
The interest paid in any form before possession of the property however, is tax deductible later. The total interest paid during the period before possession of the property can be divided into 5 installments and claimed for 5 consecutive years under section 24 upto a total maximum of Rs.2,00,000 per year. If the property is let-out, there is no upper limit to the claim under this section!
Let’s say a borrower purchased a property under construction in the year 2012. After construction, he was handed over the possession in the year 2013. Let’s say he paid a total of Rs.1,00,000 interest and Rs.50,000 as principal during the period 2012-2013. (Please note the difference between purchase and possession).
There is no Tax Benefit under 80C on the principal paid of Rs. 50,000, since he does not own the property yet. However, the entire interest paid may be deducted in 5 installments under Section 24 upto a total maximum of Rs.2,00,000 per year. Taking from the example above, Rs.20,000 (Rs. 1,00,000 divided by 5) can be claimed per annum for 5 years from the Pre-EMI paid.
While Pre-EMI and EMI may be financial decisions, you would also need to consider finer points which are not easily evaluated. Market conditions for real estate investment, reputation of the builder, resale value of your project, your current spending capabilities etc. are equally important factors.
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