Table of contents: 

  1. Introduction
  2. Benefits of taking a home loan
    • Tax benefits
    • Liquidity maintenance
    • Compounding effect
    • Credit score improvement
  3. Summary table for benefits of taking a home loan
  4. Drawbacks of self-funding
    • Opportunity cost
    • Liquidity risk
    • Reduced financial flexibility 
    • Inflation risk
    • Asset diversification
  5. Summary table for drawbacks of self-funding
  6. Conclusion

When it comes to purchasing a home, having the funds to pay outright can seem like the simplest and most straightforward option. However, even if you have the money available, considering a home loan can be a more strategic financial decision because you can take advantage of the several benefits that go beyond just owning a property. 

From maximizing tax savings to leveraging investment opportunities, maintaining liquidity, and benefiting from the power of compounding, a home loan can provide a more efficient use of your resources. Here’s how:

Benefits of Taking a Home Loan

Tax Benefits

One of the top benefits of taking a home loan is the tax benefits it offers under the Income Tax Act,  1961. 

Interest Deduction (Section 24b): You can claim a deduction of up to ₹2 lakh per annum on the interest paid towards your home loan. This deduction reduces your tax liability.

Principal Repayment (Section 80C): The principal amount repaid on your home loan qualifies for a deduction of up to ₹1.5 lakh per annum. This deduction is part of the overall limit under Section 80C, which also includes other investments like PPF, NSC, and ELSS.

Section Deduction Type Limit
Section 24b Interest Deduction Up to ₹2 lakh per annum
Section 80C Principal Repayment Up to ₹1.5 lakh per annum

 

Additionally, if you have a co-applicant, both can claim these deductions separately, provided they are co-owners and co-borrowers. This means each can claim deductions under Section 24 and Section 80C, potentially doubling the tax benefits. 

For example, a husband and wife opting for a joint home loan can claim deductions up to ₹4 lakhs on interest (₹2 lakhs each) and ₹3 lakhs on principal (₹1.5 lakh each), significantly reducing their combined tax liability. 

Moreover, the current low cost of borrowing due to favorable interest rates, typically around 8-11%, makes opting for a loan an even more attractive option. Some banks even offer lower interest rates for women borrowers, enhancing the appeal. 

Compounding Effect

By investing the money you would have used for a lump sum payment, you can reap the rewards of the compounding effect. The compounding effect is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, generate additional capital over time.

Suppose your home loan interest rate is 8% per annum, and your investment return rate is 12% per annum. By choosing a home loan of ₹40 lakh, you will pay an interest of ₹3.2 lakh annually (8% of ₹40 lakh). However, if you invest ₹40 lakh at a 12% return rate, you will earn ₹4.8 lakh annually. This results in a net profit of ₹1.6 lakh per year (₹4.8 lakh – ₹3.2 lakh). Even after paying the loan interest, your investment yields a higher return, effectively increasing your overall wealth.

Here’s a detailed calculation and table to illustrate the compounding effect over a period of 10 years: 

Year Investment Value at Start Investment Value at End (12% p.a.) Annual Earnings (12%) Cumulative Earnings Loan Interest Paid (8% p.a.) Net Profit (Annual Earnings – Loan Interest)
1 ₹40,00,000 ₹44,80,000 ₹4,80,000 ₹4,80,000 ₹3,20,000 ₹1,60,000
2 ₹44,80,000 ₹50,17,600 ₹5,37,600 ₹10,17,600 ₹3,20,000 ₹2,17,600
3 ₹50,17,600 ₹56,19,712 ₹6,02,112 ₹16,19,712 ₹3,20,000 ₹2,82,112
4 ₹56,19,712 ₹62,94,477 ₹6,74,765 ₹22,94,477 ₹3,20,000 ₹3,54,765
5 ₹62,94,477 ₹70,49,815 ₹7,55,338 ₹30,49,815 ₹3,20,000 ₹4,35,338
6 ₹70,49,815 ₹78,95,792 ₹8,45,977 ₹38,95,792 ₹3,20,000 ₹5,25,977
7 ₹78,95,792 ₹88,42,288 ₹9,46,496 ₹48,42,288 ₹3,20,000 ₹6,26,496
8 ₹88,42,288 ₹98,99,363 ₹10,57,075 ₹58,99,363 ₹3,20,000 ₹7,37,075
9 ₹98,99,363 ₹1,10,78,292 ₹11,78,929 ₹70,78,292 ₹3,20,000 ₹8,58,929
10 ₹1,10,78,292 ₹1,23,91,687 ₹13,13,395 ₹83,91,687 ₹3,20,000 ₹9,93,395

 

Credit Score Improvement

Choosing a home loan and repaying it on time can significantly improve your credit score, such as your CIBIL score and your CRIF High Mark Score. A higher credit score enhances your creditworthiness, making it easier to secure loans in the future at favourable terms. 

Here are some key benefits:

Benefit Explanation  Example
Lower Interest Rates A good credit score leads to lower interest rates on future loans. Paying home loan EMIs on time might result in a car loan at 9% interest instead of 12%, saving money over the loan term.
Higher Credit Limits Lenders offer higher credit limits to individuals with strong credit scores. Receiving a credit card limit of ₹5 lahks instead of ₹2 lahks provides more financial flexibility.
Better Credit Card Offers High credit scores attract better credit card deals, including cashback offers and rewards points. Getting a credit card with 2% cashback on all purchases and a lower interest rate of 12% per annum.

 
By consistently paying your home loan EMIs on time, you can boost your credit score across these models, enhancing your financial standing and opening up better opportunities for future borrowing.

 

Summary table for benefits of taking a home loan

Benefit Explanation Example
Tax Benefits Deductions on interest (₹2 lakh) and principal (₹1.5 lakh) Save on taxes with ₹2 lakh interest and ₹1.5 lakh principal deductions
Liquidity Maintenance Keeps funds available for other uses at a low cost of borrowing Use ₹10 lakh for down payment, invest ₹40 lakh elsewhere
Compounding Effect Earnings from investments grow over time due to compound interest Earn ₹4.8 lakh from investments, pay ₹3.2 lakh in loan interest, net profit of ₹1.6 lakh
Credit Score Improvement Boosts creditworthiness Lower rate of interest, better offers, and higher chance of loan approvals in the future. 

 

Drawbacks of Self-Funding

While paying for a home outright might seem appealing, it comes with a few disadvantages that can impact your finances and future opportunities. Here are some key drawbacks:

Opportunity Cost

Using a lump sum to buy a house upfront means missing out on potential investment returns. The money used could have been invested in avenues that offer higher returns over time.

Let’s assume you purchase a ₹50 lakh home in Bengaluru with a lump sum payment. Over 10 years, with an annual return of 8.98%, your property will be worth approximately ₹1.17 crore.

But if you make a ₹10 lakh down payment, secure a home loan for ₹40 lakh, and invest the remaining ₹40 lakhs in equity mutual funds at an assumed annual return of 12%, your investment could grow to approximately ₹1.24 crore in 10 years. 

In this scenario, your total value would be ₹2.41 crore (₹1.17 crore from the property + ₹1.24 crore from the investment), giving you an additional profit of ₹1.24 crore compared to the lump sum payment alone.

Liquidity Risk

While real estate is a solid investment, it is low on the liquidity scale. If you self-fund your home purchase, you will have very little cash available for emergencies and other financial crises. This can severely limit your ability to respond to unexpected financial needs and goals. 

For example, if you use ₹50 lakh to buy a house outright, you might struggle to cover urgent medical expenses or major home repairs. In contrast, by opting for a home loan and using only ₹10 lakh as a down payment, you keep ₹40 lakh available for emergencies and other financial goals like children’s education or starting a business. This way, you not only own a home but also maintain liquidity to handle unexpected financial situations.

Asset Diversification

Diversifying savings across various assets helps mitigate risks and ensures better long-term financial security. By investing in a mix of assets such as stocks, bonds, and mutual funds, you can spread your risk and potentially achieve higher overall returns. This diversified approach can also help manage inflation risks. 

For instance, if you allocate ₹20 lakh in equities, ₹10 lakh in bonds, and ₹10 lakh in mutual funds, you reduce the risk of losing money in a single investment and increase the potential for diversified growth. This diversified approach also helps capture higher returns and manage risks, compared to locking all your funds in a single asset like real estate.

Drawback Explanation Example
Liquidity Risk Low liquidity in real estate limits cash for emergencies Using a loan keeps ₹40 lakhs available for emergencies while buying a home
Reduced Financial Flexibility Limits ability to manage other financial goals Paying a lump sum upfront may delay other plans like children’s education or starting a business
Opportunity Cost Potential investment returns are lost ₹50 lakh invested at 12% return could grow to ₹1.55 crore in 10 years
Asset Diversification Helps spread risk and improve long-term security Reduce the risk of losing money in a single investment and increase the potential for diversified growth. 
Overall Lower Returns Investing the entire capital in real estate may result in lower overall returns compared to a diversified portfolio. For example, if you invest ₹50 lakh in real estate and it grows at an average annual rate of 7%, it would be worth about ₹98 lakh after 10 years. In contrast, if you invest the same ₹50 lakh in a diversified portfolio with an average annual return of 12%, it would grow to approximately ₹1.55 crore over the same period. The diversified portfolio offers higher returns and growth potential compared to a single real estate investment.

 

In summary, self-funding a home purchase might sound like the right thing to do, but it can limit your financial flexibility, reduce potential investment returns, and deprive you of tax benefits and credit score improvements. Opting for a home loan, even when you have the funds, provides a balanced approach that leverages financial opportunities while securing your future.

In essence, a home loan lets your money grow, giving you both a house and the peace of mind that comes with financial security.