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Monday, March 09, 2015

EMIs and pre-EMIs on Home Loans

If you have ever taken a home loan, you would have dealt with Equated Monthly Installments (EMIs), and if you have ever been involved in taking a home loan on an under construction property, you have surely dealt with 'pre-EMIs'. Let us clearly understand what separates EMIs and pre-EMIs, both from loan and from taxation perspective.... Read On...

What are Equated Monthly Installments (EMIs)?
EMI is the repayment you make to your lender every month. It is an unequal combination of your principal repayment and interest payments. To arrive at EMI, your bank will consider several parameters;

  • Principal amount
  • Repayment period
  • Rate of interest

    Thumb rule to afford an EMI
    According to the generally accepted industry thumb rule, EMI should not exceed more than 30% of your total income, considering other liabilities. But this should not be the final deciding criteria. It is always better to do your overall assets, liability, income, expense calculation before arriving at the affordability of the EMI.

    What is Amortization?
    EMI payments start once the loan has been fully disbursed. A break up of your EMIs over the entire loan term can be found in your amortization schedule. It’s important to go over your amortization schedule regularly to keep a track of any changes in interest rate or loan tenure made by the bank.

    What is Pre-EMI?

    When you buy property which is under construction, loan amount is partially disbursed to the builder, instead of being disbursed to you. When a loan is partially disbursed, only interest payments are made on that amount. These interest payments are known as pre-EMI. So the longer your builder takes to complete construction, the more interest you pay to the bank, adding on to the cost of your property.

    Tax Handling on pre-EMIs
    Pre-EMIs too have tax benefits. However, we must be careful with pre-EMI cases.
    • In a Pre-EMI situation, all interest paid prior to construction is deductible from tax, but not when you pay the interest. 
    • All such interest is added up to the possession date, and then that amount is divided into five equal installments, to be deducted over five years.
    • This deduction is on the interest component that you have paid to the bank, for the payment that the bank has directly done to the builder. 
    • The principle component is not applicable for tax deduction under Section 80 C. The reason is simple. The property should be capable of generating income (real or notional) which is chargeable under the head “Income from house property". When a house property is under construction, there is no likelihood of income, and hence under Section 80 C there is no provision for tax rebate on account of principal repayment. Only in the year in which the construction is completed can the principal repayment be considered for tax benefit.
    • In any year, this interest deduction, for self-occupied property, is limited to Rs. 1,50,000/- (under current laws) so, Rs. 30,000 each year.
    • Even when the completion Certificate is given by the builder, you cannot claim the Principal Amount paid during the construction years.

    Is paying full EMI a better option than pre-EMI?

    Even though paying pre-EMI seems more lucrative in the short run, as you have to pay only the interest component, opting for full EMI payment is more beneficial in the long run. This way you start repaying principal amount even before you get possession, reducing total cost by reducing the tenure of home loan.

    For example, in the case of pre-EMI, if loan tenure is 20 years, and the builder takes 3 years to complete construction, you will actually end up making interest payments for 23 years.

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