Many of us attach a lot of value to house ownership. Many of us also feel that house rent is a waste of money. It is better to take a home loan and pay a bit more. After a few years, you will also own the house. Contrast this with renting a house. You don’t own anything even after paying rent for so many years.
Is this the right thought process?
I don’t think so.
You pay the rent in both the cases, whether you rent a house, or you take a home loan. Just the nomenclature varies.
Rent that you pay the house owner is an expense. The money is gone. It is not helping you create any asset.
When you pay EMI, it helps you create an asset or reduce the amount you need to pay to own the house completely. However, the entire amount that you pay does not go towards reducing outstanding principal.
Let’s say you take a loan of Rs 50 lacs at 9% p.a. for a loan tenure of 20 years. EMI shall be Rs 44,986.
From your first month’s EMI of Rs 44,986, Rs 37,500 goes towards interest payment. Only the remaining amount of 7,486 (Rs 44,986 – Rs 37,500) will go towards the repayment of the principal. Therefore, even though you paid Rs 44,986, your loan amount reduced by only Rs 7,486 to Rs 49.93 lacs. I have discussed these calculations in detail in this post.
What does this tell us?
This interest paid on a housing loan is an expense too. It is the rent paid to the bank.
Over the course of 20 years, you will pay a total of Rs 1.08 crores to the bank in EMIs. The loan amount is only Rs 50 lacs. The remaining 58 lacs is the interest or rent paid to the bank for borrowing money to purchase the house.
Essentially, you must choose between:
Whether you should pay rent to owner OR you should pay rent to the bank?
Which approach is better? Rent vs. Buy
Let’s dig deeper with an illustration.
We will compare the rent outgo (actual rent vs interest payments) in both the cases and see where we pay a lower rent.
Let’s assume the house rent is Rs 35,000 per month. Instead of renting the house, you can buy the house and stay in it. How much would such a house cost you? The rental yields in major Indian cities fall between 2-3%.
Rental yield is Annual Rent/Value of the house. Therefore, if a property with market value of Rs 1 crores fetches monthly rent of Rs 20,000, its rental yield will be Rs 2.4 lacs/Rs 1 crore = 2.4% p.a. Rental yield will increase if the rent increases or the value of the property decreases. Rental yield will also increase the monthly rent increases faster (or decreases slower) than the value of the property. For the rental yields to decrease, exactly the reverse must happen
Let’s assume the rental yield to be 2.5%.
Rs 35,000 per month = Rs 4.2 lacs per annum. At a rental yield of 2.5% p.a., the market value of the property should be Rs 1.68 crores. Let’s say you put down a down payment of 25% i.e. Rs 42 lacs. You take out a loan for the remaining amount of Rs 1.26 crores.
Loan Amount: Rs 1.26 crores, Loan Tenure: 20 years, Interest Rate: 8.5% p.a., EMI: Rs 1,09,346
I assume that the house rent will grow by 5% every year.
For the purpose of this analysis, I will ignore transaction costs such as brokerage, stamp duty etc. I have ignored the impact of maintenance charges that you must pay if you own the house. I will ignore the tax benefits of home loan repayment under Section 80C and Section 24. I will also ignore the tax benefits due to House Rent allowance. Further, I assume that the interest rate will remain constant during the tenure of the loan at 8.5% p.a.
Let’s see how the numbers look.
In the last column, you have the difference between the interest paid to the bank and the rent paid to the owner. Rent paid to the owner is slightly higher. However, given the amounts involved, the difference is almost negligible. It could have tilted in the other direction with minor changes in rental yields or interest rates.
The above analysis shows that you can be indifferent to the two scenarios. Rent paid to the landlord/owner is almost the same as the interest paid to the bank.
But I own the house if I paid EMIs
That’s right. You will own the house after 20 years if you went with the EMI option.
However, in your EMIs, you just didn’t pay the interest, you repaid the entire principal amount of Rs 1.26 crores.
Therefore, by opting to rent a house, you saved the principal repayment too. In the example considered above, about Rs 1.24 crores.
In fact, you could have stayed on rent and saved Rs 1.24 crores + down payment of Rs 42 lacs and purchased the house at the end of 20 years.
But the house will appreciate in value
So will your savings.
In addition to the down payment of Rs 42 lacs, you also save (EMI-Rent paid) every month.
I will use crude calculations to arrive at what these savings can grow to.
At 6% per annum, down payment and monthly savings will grow to Rs 3.97 crores per annum. This takes care of capital appreciation in the property by up to 4.32% p.a. This means, if the property appreciates at the rate of 4.32% p.a., you can purchase the house after 20 years from your savings.
At 8% per annum, these savings will grow to Rs 5.26 crores. This is enough to meet the capital appreciation of up to 5.88% in the property price.
At 10% per annum, the savings will grow to Rs 7.09 crores. This is good enough to handle appreciation in property price of up to 7.47% p.a.
Could the results be different?
We have made several assumptions about rental yields, loan interest rates and percentage increase in rentals. If we change the assumptions, the results could be different.
The numbers can tilt towards the purchase of the house
- If the rental yields were higher
- If the loan interest rates were lower
- If the house rent increases at a higher rate
- If the property prices appreciated faster
The numbers can tilt towards renting the property
- If the rental yields were lower
- If the loan interest rates were higher
- If the house rent increases at a slow rate
- If the property prices did not appreciate fast
What does this all mean?
I do not intend to settle Buy vs Rent debate. There are many factors that can’t be quantified.
For instance, for many, home ownership is a status symbol. Home ownership may provide a sense of financial security and emotional comfort. Your family may want that your kids grow in a house you own. You can’t price memories, can you?
On the other hand, how do you price the flexibility that staying on rent offers you? You can shift within the city or to a different city without breaking your head too much. Your new office is far away from your current residence. You can shift to a house that is closer to your new office. You can choose the size of your house depending on your requirements. Had you bought a house and the area didn’t develop as well as you expected, you would be worried. Not when you have rented the house.
My analysis only looks at the financial costs. There is no consideration to the subjective and emotional aspects.
I only want to disprove the belief that the house rent is a waste of money and that buying a house on a home loan is a better choice. Mathematically, it is not. You pay the rent even when you borrow from the bank. And as we saw above, the two rents are almost equal.
In my opinion, you must plan to purchase a house at a place where you can settle after retirement. And you must purchase this house before you retire. Even though you do not plan to buy anytime soon, keep planning for it by making the right investments. If you have an ancestral house where you would want to settle after you retire, you don’t have to plan for this house purchase. You might ask why no mathematical analysis for this. In my opinion, beyond an age, you would not want to shift too many places and I attach a lot of value to this aspect. You don’t have to feel the same way. If the house rental industry could become more professional, my opinion can change.
About residential real estate as an investment, I won’t be very keen as long as rental yields are very low. With low yields, the entire bet is on capital appreciation, which is a bit tricky. The real estate market is heterogeneous. Everything depends on your investment skills (picking the right location) and partly on your luck.