Renting Vs Buying A House

Sanjay's dilemma – To live on rent or buy a home

Sanjay is a 35-year-old CA with a reputed accountancy firm and brings home a salary of Rs 1,00,000 per month. He is living with his family in a rented flat that costs him Rs 25,000 per month. Till a few years back, buying a house was a distant dream for him. But the falling property prices and attractive home loan rates have given him a new hope. He is contemplating of buying the same flat which is currently fetching a price of Rs 70 lakh. He can even use his savings of Rs 15 lakh as down payment. But before making any decision he wants to weigh all his options.

Sanjay has two options in front of him:

• To continue living on rent
• To buy a house

He does not want to make any decision on the spur of the moment, so he splits the entire calculation into four steps:

What is Sanjay's monthly outflow?

CASE 1.When the flat is rented

Sanjay's primary outflow is the rent that is Rs 25,000 per month, means Rs 3,00,000 per annum. If he considers an annual hike of 5% in the monthly rent, then his yearwise monthly outflow will be as below:

CASE 2. When the flat is purchased

In this case, Sanjay's monthly outflow will comprise the EMI.

A. EMI calculation
The purchase price of the flat is Rs 70 lakh, including cost of registration and stamp duty.
Generally, down payment is 20% of the house price. This comes to
Rs 70,00,000 x 20% = Rs 14,00,000
This is not a problem as Sanjay already has Rs 15,00,000 with him.

So, the loan amount Sanjay would need will be Rs 70,00,000 – Rs 15,00,000 = Rs 55,00,000.

See different EMIs Sanjay would pay across different interest rates & maturity periods

B. Monthly outflow calculation

If Sanjay takes a loan of Rs 55 lakh at the interest rate of 9% for 20 years, his EMI comes to Rs 49,485 i.e., Rs 5.94 lakh per annum.

He gets tax benefits on the principal as well as the interest payments.

At the same time, he has to bear annual maintenance charges of Rs 30,000 (approx.) for the flat.

His yearwise monthly outflow will be:

Equating rent and buy outflows

Now, Sanjay has calculated monthly outflows in both cases. A comparison between the two will help him arrive at a decision. So let's take a look at it.

A) When interest rate is 9%

The data shows that the buy outflow is almost constant for the entire duration, while a rising curve can be seen in the case of rent outflow. This means initially the rent outflow is less compared to the buy outflow, but after some period say 15 years they converge at a point, and thereon we see a rise in the rent outflow.

In the above case, buying a flat looks good option for Sanjay. However, there are certain possibilities that have to be taken into consideration before making a final decision.

B) When interest rate is 12%

If the floating rate increases to 12%, the EMI will also rise, unless the tenure is increased. Check out the monthly outflow in that case:

Property appreciation (Rent vs Buy)

The flat Sanjay is buying will also act like an investment and generate annual returns as property prices move up. Let us sum up the outflow and gains:

Outflow

• Down payment of Rs 15 lakh
• Rental deposit of Rs 2 lakh
• Paying interest rate of 9% on the loan

Gains/investment

• Appreciation of property value at 4% over 20 years
• Tax savings in case of buying
• Interest earned on rental deposit

The chart shows the overall Internal Rate of Return (IRR) generated by the investment over 20 years.

Here, we see that buying turns out a good proposition for Sanjay as he earns an impressive return of 9.62%.

This return should be compared with other investment options like PPF, Mutual Funds, etc. However, it is advisable to go for a house of your own even if the returns are moderate.

Risk evaluation

We have made some assumptions while calculating investment returns for Sanjay, but changing scenarios can have different impact on the returns.

Risk 1: Property appreciation

We assume that the value of flat will appreciate at 4% per annum. Let us therefore look at the various returns that Sanjay might earn if appreciation scenarios are different.

Risk 2: Change in interest rates

Sanjay did his calculation by keeping the interest rate constant at 9% for the entire loan duration. But if the floating interest rate moves up or down, the whole calculation will change, impacting the returns generated by the investment. Check out the internal rate of return for changing interest rates (property appreciation is kept fixed at 4% p.a.).

Risk 3: Change in annual rentals

The rental growth was considered to be constant at 5% per annum in the calculation. However, it can be higher or lower depending on the direction in which property prices move in that period. Let's see the IRR changes with respect to change in annual growth of rentals (assuming interest rate as 9% and property appreciation 4%).

Summing it up

• Sanjay's rent is much lower than the EMI in the initial years, but it will later increase and surpass the EMI
• Even though the EMI is higher, an appreciation in the cost of the property will make up for it.
• Property should be bought at the right time and for right price. So for Sanjay, it will be a wise decision to buy the flat at Rs 60-70 lakh.
• Had Sanjay's rent Rs 20,000, then it would have made sense for him to live on rent.
• He should take a loan at lower rates or wait for rates to fall.
• There are ups and downs in the floating interest rates. Rising rates can strain his pockets, so he must be prepared for a 10-20% increase in the EMI.

* Above recommendations do not take into account rapid increases in rents or property