Recently, the news about banks holding back on new home loan overdraft accounts has been floating in the market. Banks that are not completely closing this product are looking forward to tightening the regulations around it such as ceiling the money in overdraft account. So why is this happening? Why are banks shying away from a product which they earlier used to promote as an innovative home loan saver option?
Before we find out why banks are taking these steps, let us first understand what home loan overdraft is?
What is overdraft (OD)?
Home loan overdraft facility is offered with a home loan account under which you can park any extra amount. This surplus amount parked in the home loan overdraft account is treated as pre-payment towards your home loan and the same is deducted from your home loan principal. In this way, you can save on the interest pay-out as interest will be charged on the balance home loan principal. Moreover, you also have the option to withdraw the parked amount as and when you want. Any deduction in the home loan overdraft account will lead to an equal rise in the home loan balance.
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Here’s an illustration to explain the concept-
Sumit took a home loan of ₹50 Lakhs for 20 years at a rate of 9.50 percent. So, his home loan EMI is ₹46,607. Since home loan is a front-loaded loan, EMIs in the initial period will have more interest component than principal. So, in the first year, the EMI of ₹46,607 is composed of about ₹39,000 of interest and only about ₹7,000 of principal.
Now, Sumit happens to have a surplus amount of ₹3 Lakh and wants to make prepayment towards the loan after regularly servicing the EMIs for 2 years. If he does, the total outstanding principal gets reduced to ₹ 45,15,168. His loan tenure will be reduced but the EMI outgo will remain the same as before. Even if he chooses to restructure the EMI, the ratio of principal and interest remains unchanged. On the other hand, if he chooses to put this amount in a home loan overdraft account, interest will be charged on the balance of ₹ 45,15,168 and the EMI comes down to ₹ 43,703.
How a home loan overdraft account benefits the borrower?
A home loan overdraft account helps the borrower save a lot of interest without going into the burden and paperwork of transferring the balance to a bank that charges lower interest rate. So, it is a good option for those who have surplus fund inflows. In addition to this, it offers greater liquidity since you can withdraw the parked money as per your need, as opposed to the ordinary prepayment wherein the money is gone forever.
Financial experts say that interest saved is interest earned so they advise people with huge home loan balance to park their surplus fund in a home loan overdraft account. A reduction in the overall interest outgo will also help you close the loan faster. Home loan overdraft is suitable for families that consist of more than one salaried individual so that the chances of surplus fund inflow are higher. It is also good for businessmen who regularly earn more than expected or get windfall gains every now and then.
One drawback of this account is that the extra amount repaid towards your home loan does not qualify for tax deduction under section 80(C) of the Income Tax Act, as it is not considered as prepayment. The interest saved will also be a part of the available balance in your home loan overdraft account and will not qualify for tax rebate under section 24. Moreover, the interest rate on home loan with overdraft feature may be slightly higher than that on ordinary loans. So, a borrower should do a cost-benefit analysis to find out whether the cost of the loan weighs down the benefits of interest-saving through the overdraft account.
Why are banks holding back on Home Loan Overdraft?
The trend of home loan overdraft was started by the multinational banks in India with an aim to lure Indian customers followed by Indian private banks and some public sector banks. Only a few banks are currently offering this product such as SBI MaxGain, HSBC Smart Home, Citi Bank Home Credit, Axis Bank Super Saver Home Loan, etc. Though a home loan overdraft account is quite beneficial for the borrowers, for the banks it is not much of a profitable deal. This is why a number of banks have announced a complete discontinuation of the product while others have made the regulations around this product more stringent.
Lenders face dual loss on this scheme. Firstly, if the borrower opts for this scheme and keeps a big amount in the overdraft account, the bank is going to lose a lot in terms of slashed interests as they will have to charge interest only on the balance outstanding principal. Secondly, banks are legally required to offset the risk of big loans like home loans through a process called provisioning in which they have to set aside an amount equivalent to the amount of loan.
When an overdraft facility is used by the borrower, they are not only losing on the interest income but also making provisions for outstanding loans with the money that can be used for more profit-earning ventures.
Money that borrowers save by parking surplus funds in the home loan overdraft account is a loss for the banks. In Sumit’s case, had he put the ₹3 Lakh in a savings account offering interest at the rate of 4 percent, he would earn ₹1,000 in a month. But if he puts the amount in a home loan overdraft account attached to a home loan at 9.5 percent, the total savings would be ₹2,375 in a month. The difference of ₹1,375 a month will be a loss to the bank.
Owing to the above reasons, banks are trying to make this product less of a liability for them. Some banking MNCs have started charging annual fee on home loan overdraft account. Others have designated a maximum amount that one can park in the overdraft account. Making the product more restrictive will discourage people from availing it thus saving the banks from these losses.