How you can benefit from a home loan with OD facility

When Sunita approaches her bank, the relationship manager there puts forth a proposition. “There’s a type of home loan that lets you temporarily park surplus cash in the loan account, whereby the outstanding principal is reduced by an equivalent amount and thus reduces the total interest on the loan. The best part is that you don’t actually have to part ways with your liquid cash, unlike a prepayment, and you can withdraw the deposited amount anytime you want," manager says.

“Really? What happens to the outstanding principal when I withdraw the surplus cash?," asks Sunita.

“Well, the interest will be recalculated after increasing the outstanding loan by the amount withdrawn. But the upside is that you will have used your surplus to partly reduce the overall interest you pay on the loan," explains the RM.

“But I can park the money in a fixed deposit and earn interest on that," she counters.

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“Yes, but the FD interest rate will most likely be less than the rate you will pay on the loan. You can get a higher rate with a long-term FD, but in that case your money will be locked away for several years, right? And if you break the FD prematurely, the bank will charge a foreclosure penalty and you won’t earn the full interest either. Let me give you another perspective. If you use surplus cash to make a prepayment, but need money a few days later for an emergency, a personal loan will be way more expensive than your home loan."

“Do I have to open a separate savings account?"

“No, the money is deposited in your loan account itself."

“Is there a fee when I deposit or withdraw the money? Also, can I withdraw my entire deposit?"

“No, there are no charges at all. And yes, you can withdraw the full amount whenever you want. In fact, say you’ve deposited ₹5 lakh and need ₹1 lakh for your business. You can just withdraw that amount while keeping ₹4 lakh in the loan account to reduce your interest payments."

“Come on, there has to be a catch."

“Not really, no. Except that you will have to pay a slightly higher interest rate— 5 to 50 basis points more. But I promise to get you the best rate possible because you have been a loyal customer of the bank for so many years!"

“Ah, so there’s the catch."

“Well, from the bank’s perspective, it can’t use the surplus deposited with it for any purpose because it’s not locked for a predetermined tenure. So it charges this small premium for the opportunity cost."

“Will I earn interest on the money deposited?" Sunita asks with a chuckle.

“Of course not!"

What’s the deal?

Does this sound like a good deal? It certainly ought to be. The home loan with an overdraft (OD) facility, as this product is known, is offered by most banks as a standalone product. For instance, we have Axis Bank’s Super Saver loan, SBI’s MaxGain, and ICICI Bank’s Money Saver, to name a few.

This is similar to an OD for a current or savings account, except that the limit in a home-loan OD is linked to the disbursed loan. “Home-loan OD is not a perpetual OD. The bank has to close it as per the tenure of the loan, so it keeps reducing the limit by the monthly principal portion of the EMI (equated monthly installment)," said Nishant Batra, co-founder and director, Holistic Prime Wealth, a mutual fund distributor registered with the Association of Mutual Funds in India (AMFI).

Also read: What you can do if your home loan interest rate is more than 9%

Apart from the surplus money deposited, the borrower gets an additional credit limit equivalent to the outstanding loan. Tapping this credit limit means that you are taking a loan on the interest rate of your home loan, which will most likely be less than interest rates on a personal loan or even a credit card.

Banks usually cap the permissible withdrawal amount at 20-25% of the outstanding loan. “Banks put this cap to avoid loan ever-greening through the OD facility," said Adhil Shetty, co-founder and CEO, BankBazaar.

The EMI on an OD home loan works like any other home loan and is debited from the repayment account mapped to it, said Sumit Bali, group executive and head of retail lending at Axis Bank.

Is this right for you?

Such a home loan may seem like a natural choice for any borrower who wants to use surplus cash to reduce interest on the home loan at regular periods and also have a credit line available. However, it only makes sense in specific cases.

For one, it may not work for the majority of salaried individuals. “In a year, how many times does a salaried individual have surplus cash? They will get a bonus, but what are the chances they will use this for their loan? It’s not advisable to pay a higher interest for a feature that you’re unlikely to use," said Shetty.

On the other hand, business owners who typically have a temporary cash surplus at regular intervals can deploy this in the loan account to earn 8% interest instead of leaving it in a savings account for 2-3%.

Also, the reduced balance and corresponding interest in an OD loan is calculated daily, and the EMI changes periodically depending on deposits and withdrawals. This would require the borrower to closely track their bank statements every month to ensure the bank is calculating the interest correctly. Note that the Reserve Bank of India recently pulled up banks for charging extra interest from borrowers, which indicates that you can’t blindly rely on the bank to charge the interest correctly.

Also read: Charged ‘extra’ interest on a loan by your bank? Here's what to do.

Borrowers who understand how loans work and can read statements easily will be able to do this easily. As for the others, if they are able to substantially reduce the interest by either parking large amounts for six months or more, the hassle may be worth the effort.

Also keep in mind that most banks don’t allow prepayments on loans with an OD facility.

(Sunita's case is hypothetical.)