What is Home Loan with Overdraft Facility
A home loan overdraft is the same as the overdraft limit on the current or savings account where the borrowers can deposit an advance or extra funds. In the case of a home loan overdraft, the borrowers’ account is linked to a dedicated savings account by the lender. So, when a borrower adds the surplus money to the account, it will be considered pre-payment towards the loan, thus reducing the interest on the outstanding loan amount. In a way, it effectively brings down the overall liability as the interest is only being charged on the outstanding balance.
Also, if needed, the overdraft option allows you to withdraw money whenever required. It is typically used for lump sum expenses like medical emergencies, house expenses, weddings, etc. The loan can get rebalanced accordingly. The best advantage of this scheme is probably the liquidity it offers. However, any rise in the outstanding balance of a home loan can subsequently increase the interest rate.
However, the interest will only be charged on the amount exceeding the account balance for the period it was drawn. To protect themselves from the risk, Lenders put a limit on the withdrawal amount. It is mostly 25% of the loan amount, but it may depend on each bank’s internal policies.
How Does A Home Loan Overdraft Facility Work?
This facility generally makes sense for those who have the assurance to save extra money over and above the regular EMIs. Once you take on the overdraft scheme, you can directly transfer the savings account funds to your home loan account. As mentioned above, the interest payable on the home loan is calculated on the outstanding loan, so the more you deposit, the sooner you will be able to pay it off.
With this facility, the borrower has the right to deposit or withdraw as many times during the tenure, giving the flexibility to manage the cash flow.
Pros of Overdraft Facility in a Home Loan
As the facility is becoming popular among borrowers as an investment option, it is crucial to learn the reasons for the same.
Withdraw the surplus fund as needed
Taking an overdraft home loan has many advantages. Overdrafts are very liquid. They allow you to withdraw money from your account up to an agreed limit, and the bank will let you do it as many times as per your convenience. This flexibility can be beneficial during financial emergencies.
With this type of home loan, you can use your savings account to cover extra expenses. It’s an excellent option for those who aren’t cash crunched. Pre-paid penalties can be avoided, thus reducing the overall interest cost.
Avoid prepaid penalties
With an overdraft home loan, the liability for prepaid balances can be avoided. It’s a great way to avoid the high cost of pre-paid penalties and still use the account when required. If not cautious, there is a chance of paying a hefty fee for withdrawing money from the savings account before it reaches the preset limit. An overdraft home loan will help you avoid these penalties altogether.
Ability to repay the loan before the agreed tenure
One of the most significant advantages of an overdraft home loan is that it can be repaid before the stipulated tenure. It’s a perfect option if you want to repay the loan in a few years. Let’s understand with an example.
Home loan overdraft: An illustration
For instance, in January 2019, Mr Kapoor took a home loan of INR 80 lakh for a tenure of 20 years at an interest rate of 8.6%. As per the calculation, he will be paying a monthly EMI of INR 70,000.
Now, let us assume that Mr Kapoor has a surplus of INR 4 lakh, and he makes a partial payment after 24 regular EMIs to reduce his total amount.
Pre-paying the extra funds will keep the EMIs unchanged in an ordinary home loan. The principal-interest ratio is unchanged. However, in a home loan overdraft, if Mr Kapoor pays INR 4 lakh to the account linked to the home loan, the EMI will reduce to INR 66,000 from the next month, decreasing the tenure.
Here the interest is calculated on the outstanding principal amount. So the more money you put in your account, the more interest outgo your diminish.
Cons of Overdraft Facility in a Home Loan
The overdraft facility also comes with a cost and, as said, no one size fits all. This means it might be a great option but doesn’t work for everyone.
For specific borrowers
The main disadvantage of overdraft home loans is that they are not beneficial for people who need to save money. This type of loan also has an increased risk for people who are unable to maintain their current finances. They will be required to pay the entire amount back in one lump sum, which can be difficult if they do not have enough money on hand. This means that if you use the overdraft facility for your regular expenses, it will be expensive in the long run.
Higher interest rate
Consumers are often lured into taking out an overdraft home loan because of its flexibility to use funds when required. However, this benefit can sometimes cost a borrower much more. These loans are relatively high-interest rates. They are usually higher than a standard conventional home loan. For instance, if a regular home loan is available at a 6.8% interest rate p.a., the one with the overdraft facility may charge you 7.2% p.a. This means that these loans need to be paid off quickly to save on interest payments.
Many people don’t know this till they have already signed up for it. This is because the terms and conditions are not always clear on how they will be charged. So, before you make the final decision, make sure to compare the interest rates of both options.
No tax benefit
One unavoidable con of this facility is that it doesn’t provide the borrower with tax benefit under section 80C on additional payment on a home loan as the surplus amount.
Should You Use an Overdraft or a Normal Home Loan?
The use of the facility depends on personal use and financial situation. If you think there is a possibility of funds requirements for your child education or home improvements in the future, then it can be beneficial for you. However, it should be kept in mind that it’s an open-ended borrowing facility and should not be misused for non-essential purchases.
And while you get access to a larger pot of cash, it is essential to clear your balance before the interest-free deal ends. This can be done by tracking your account balance often. Check how much money you deposit into the account and how much you take out for bills and other payments.
Banking transactions such as:-
- Transfers between accounts
- E-banking
- Debts like car loans, rent, recurring bills, gym membership etc.
- ATM withdrawals
- Cheques
These can easily be tracked by signing up for free electronic alerts. It’s always important to keep yourself informed about your account.
Bottom Line
Firstly, while taking a loan, a borrower has a lot of things in mind such as repayments, maintenance of credit score, and checking other debts. The overdraft facility impacts your overall credit rating by adding to your indebtedness. Lenders are likely to see how you clear your overdraft balance to manage their risk. And if it’s poorly done, it will negatively impact your credit scorecard.
That said, if banks are providing you with these services, go for it but be very cautious and conduct a proper cost-benefit analysis. The analysis will help you know if the amount saved in pre-payments is more or less than the cost of a traditional home loan.
Secondly, borrowers often know that they will earn the interest through pre-paying the amount. However, pre-paying an extra fund will only reduce the outstanding balance and the interest outgo. Lastly, not all financial institutions provide this facility, so consider all factors like terms and conditions before choosing a lender. It will help you make an informed decision, slash your interest burden, and make you debt-free.
