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Should You Opt For Home Loan With An Overdraft Facility?

Part-prepayment of our home loan, is one of the first thoughts, whenever we have extra cash in hand. The amount so repaid, is in addition to the EMIs being paid by us every month. This reduces the total interest burden over the loan tenure.

However, this has one drawback... we cannot withdraw this surplus amount repaid, if later we have some requirement(s). Prepayment, once done, is permanent.

This is where the Home Loan with Overdraft Facility comes useful.

- not only enables us to slash our interest burden on the home loan,
- but also allows us to utilize the extra money whenever we need it.

In short, this gives us both Cost Savings and Liquidity.

Beware! This may not always be a win-win situation.

There are both pluses and minuses to this approach.

But, before we explore the same, here's how this simple facility works.

Under this scheme, an overdraft account is opened and linked to your home loan account. This overdraft account works like any normal bank account, wherein you can deposit or withdraw cash as and when you wish to.

But, unlike a savings account, you don't get any interest on this balance.

Which is good...
... because this extra cash, lying in your overdraft account, is considered as principal repayment for the purpose of calculating the interest payable on the home loan.

Accordingly, as the 'effective' oustanding principal is lower (= actual loan amount oustanding - balance in the overdraft account), your interest liability too is lower — till the cash remains in the account.

When you withdraw the amount, the outstanding principal goes back to the normal amount and interest payable too is back to normal.

In other words, as long as you maintain a balance in the overdraft account you save on interest cost. If the balance is zero, you pay normal interest, as you would have in the usual course. Plus, you are always free to use this money.

Since the EMI is constant and the interest is lower than the normal calculations, more money is available to be adjsuted towards the principal. Thus, your loan get repaid earlier than the contracted tenure.

Now for the pros and cons:

1. Rate of interest
The home loan with overdraft facility may come with a slightly higher rate of interest on the home loan. So, if the normal home loan is available at 10% p.a., the one with overdraft facility may charge you 10.25% p.a.

This is one drawback of home loan with overdraft facility.

So be very sure to compare the interest rates under both options, before you take the final decision.

Wondering whether an Overdraft Account linked to Home Loan is Ok or not?

2. Expected surplus
For this scheme to be really beneficial, the expected balances that you can maintain should be reasonably high. Else, the gains will be too small to make any meaningful reduction in your total interest burden.

More importantly, the balances that you can expect to maintain in the overdraft account, should be large enough to offset the higher rate of interest mentioned earlier. If your balances are small sums only, then you would be a loser. Interest savings due to overdraft account balance, will not compensate for the extra interest applicable.

For example, a 20-year Rs.50 lakhs home loan would require you to always have at least around Rs.38,500 as average balance in the overdraft account to break-even (assuming normal home loan at 8.75% p.a. and one with OD facility at 9% p.a.). 

3. Sec 80C tax benefit
Normal prepayments are considered as home loan principal payment for the purposes of tax benefit u/s 80C. Thus, you can save tax on such prepayments.

However, amounts put in the overdraft account do not qualify as home loan principal payment u/s 80C. So no tax deductions, if you choose to opt for overdraft facility vis-a-vis normal prepayment.

4. Banking transactions
If, in the normal course, there are many inflows and outflows in your bank account (e.g. in case of a business), the overdraft facility works quite well.

Instead of the normal account, you use the home loan linked overdraft account. Thus, on one hand you keep making your usual banking transactions. While, on the other hand, the day-to-day available balance in the account saves you on the home loan interest.

5. Tax efficient returns
Assuming these extra funds were required at a later date, you would have normally created a Fixed Deposit for the same. However, as you know, the interest earned on the same is taxable.

Whereas, if the same money was parked in the overdraft facility, there would no tax implications on the interest saved (assuming your total interest for the year, was more than the maximum allowable deduction i.e.Rs.2 lakhs, even after the interest savings).

6. Investment as an alternative
In some instances, neither normal prepayment nor the overdraft facility may be a good idea.

If the relevant factors are all favourable, it may instead be better to invest the surplus cash. This is particularly true if you can invest in the equity markets (assuming you have the risk appetite and at least 5-7 years investment time frame). This would probably enable you to earn more returns than what you otherwise pay as home loan interest.

As such, on a net-net basis, this would prove to be a more productive proposition.

Concluding: Home Loan with Overdraft Facility is an interesting and useful concept. It can slash your interest burden and make you debt free earlier than the contracted tenure. But, given a few drawbacks, you need to analyze whether it suits your particular circumstances or not.

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