A home loan overdraft is the same as the overdraft limit on the checking or savings account where borrowers can deposit an advance or additional funds. In the case of a mortgage overdraft, the borrowers’ account is linked to a savings account dedicated by the lender. So, when a borrower adds the excess money to the account, it will be considered a prepayment of the loan, thereby reducing the interest on the outstanding loan amount. In a way, this effectively reduces the overall liability, as interest is only charged on the outstanding balance.
In addition, if necessary, the overdraft option allows you to withdraw money at any time. It is generally used for lump sum expenses like medical emergencies, house expenses, weddings, etc. The loan can be rebalanced accordingly. Probably the best advantage of this scheme is the liquidity it offers. However, any increase in the outstanding balance of a home loan may subsequently increase the interest rate.
However, interest will only be charged on the amount in excess of the account balance for the period it was charged. To protect against risk, lenders impose a limit on the amount of withdrawal. It is mainly 25% of the loan amount, but it may depend on the internal policies of each bank.
How does a mortgage overdraft facility work?
This setup usually makes sense for those confident of saving extra money beyond regular EMIs. Once you have subscribed to the overdraft scheme, you can directly transfer the funds from the savings account to your home loan account. As mentioned above, the interest due on the home loan is calculated on the outstanding amount of the loan, so the more you deposit, the faster you can 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 cash flow.
Highlights of the Overdraft Facility in a Home Loan
As the facility becomes popular among borrowers as an investment option, it is crucial to know the reasons behind it.
Withdraw excess funds as needed
Taking out an overdraft mortgage 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 this as many times as you want. This flexibility can be beneficial during financial emergencies.
With this type of home loan, you can use your savings account to cover additional expenses. It’s a great option for those who aren’t short on cash. Prepaid penalties can be avoided, reducing the overall cost of interest.
Avoid prepaid penalties
With an overdrawn home loan, liability for prepaid balances can be avoided. It’s a great way to avoid the high cost of prepaid penalties while still using the account as needed. If you are not careful, you may end up paying high fees to withdraw money from the savings account before it reaches the preset limit. An overdrawn home loan will help you avoid these penalties altogether.
Ability to repay the loan before the agreed term
One of the most important advantages of an overdrawn home loan is that it can be paid off before the stipulated term. It is a perfect option if you want to pay off the loan in a few years. Let’s understand with an example.
Home loan overdraft: An illustration
For example, in January 2019, Mr. Kapoor took out a home loan of INR 80 lakh for a term of 20 years at an interest rate of 8.6%. According to the calculation, he will pay a monthly EMI of INR 70,000.
Now suppose Mr. Kapoor has an excess of INR 4 lakh and makes a partial payment after 24 regular EMIs to reduce his total amount.
Prepaying the additional funds will keep the EMIs unchanged in a regular home loan. The capital-interest ratio is unchanged. However, in the case of a home loan overdraft, if Mr. Kapoor pays INR 4 lakh into the account linked to the home loan, the EMI will be reduced to INR 66,000 from the following month thus reducing the term.
Here, interest is calculated on the outstanding principal amount. So the more money you put in your account, the lower the interest you spend.
Weak overdraft facility in a home loan
The overdraft facility also has a cost and, as mentioned, there is no one-size-fits-all solution. That means it could be a great option, but it won’t work for everyone.
For specific borrowers
The main disadvantage of short mortgages is that they are not advantageous for people who need to save money. This type of loan also presents an increased risk for people who are unable to maintain their current finances. They will be required to repay the entire amount at once, which can be difficult if they don’t have enough cash on hand. This means that if you use the overdraft facility for your regular expenses, it will cost you dearly in the long run.
Higher interest rate
Consumers are often enticed to take out an overdrawn home loan because of its flexibility to use the funds when needed. However, this advantage can sometimes cost a borrower much more. These loans are at relatively high interest rates. They are generally higher than a standard conventional mortgage. For example, if a regular home loan is available at an interest rate of 6.8% per annum, the one with the overdraft facility may charge you 7.2% per annum. This means that these loans must be repaid quickly to save on interest payments.
Many people don’t know this until they have already signed up. Indeed, the terms and conditions are not always clear on how they will be charged. So, before making the final decision, be sure to compare the interest rates of both options.
No tax benefit
An unavoidable drawback of this facility is that it does not provide the borrower with a tax benefit under Section 80C on the additional payment on a home loan as an excess amount.
Should you use an overdraft or a normal home loan?
Facility usage depends on personal usage and financial circumstances. If you think funds may be needed for your child’s education or home improvements in the future, this may be beneficial for you. However, it should be kept in mind that this is an indefinite loan facility and should not be misused for non-essential purchases.
And although you have access to a larger pot, it is essential to clear your balance before the end of the interest-free offer. This can be done by tracking your account balance often. Check how much money you deposit into the account and how much you withdraw for bills and other payments.
Banking transactions such as: –
- Transfers between accounts
- online bank
- Debts such as car loans, rent, recurring bills, gym membership, etc.
- ATM withdrawals
These can easily be tracked by signing up for free email alerts. It is always important to keep you informed about your account.
First of all, while taking a loan, a borrower has many things in mind such as repayments, maintaining credit rating and checking other debts. The overdraft facility impacts your overall credit rating by increasing your debt load. Lenders will likely see how you clear your overdraft balance to manage their risk. And if done incorrectly, it will negatively impact your credit score card.
That said, if banks provide you with these services, go for it, but be very careful and do a proper cost-benefit analysis. The analysis will help you know if the amount saved in prepayments is more or less than the cost of a traditional home loan.
Second, borrowers often know that they will earn interest by prepaying the amount. However, prepaying additional funds will only reduce the outstanding balance and interest expense. Finally, not all financial institutions offer this facility, so consider all factors like terms and conditions before choosing a lender. This will help you make an informed decision, reduce your interest burden and free yourself from debt.