Should You Take Home Loan And Buy A House Or Continue To Live In A Rented House

Picking out the right option

Mahesh is a 30-year-old salaried professional who earns a gross salary of Rs 40,000 a month. He is currently living in a flat on a monthly rent of Rs 10,000. But with attractive home loan schemes hitting the market every day, he is contemplating to buy the same flat at around Rs 20 lakh. He has Rs 4 lakh available for the mandatory down payment.

So, Mahesh has the following two options:

• To live on rent
• To buy a house

But Mahesh does not want to take a hasty decision and repent later. He wants to analyse both the options first, so he splits the entire calculation into four steps:

What is Mahesh's monthly outflow?

Case 1: When the flat is rented
Mahesh's primary outflow is the rent that is Rs 10,000 per month, means Rs 1,20,000 per annum. If he considers an annual increase of 5 per cent in the monthly rent, then his yearwise monthly outflow will be as below:

Case 2: When the flat is bought
In this case, Mahesh's monthly outflow will comprise the EMI.

A. EMI calculation

• Mahesh will bear a total cost of Rs 20 lakh (approx.) which includes price of the house, registration fees and stamp duty.
• Generally, down payment is 20 per cent of the house price. This comes to Rs 20,00,000 x 20% = Rs 4,00,000. This is not a problem as Mahesh already has Rs 4,00,000 with him.
• So, the loan amount Mahesh would need will be Rs 20,00,000 – Rs 4,00,000 = Rs 16,00,000.
• Click here to find the various EMIs Mahesh might have to pay across varying interest rates and maturity periods of the loan

B. Monthly outflow calculation

• If Mahesh takes a loan of Rs 16 lakh at the current market rate of 10 per cent for a period of 20 years, his EMI comes to Rs 15,440, i.e., Rs 1.85 lakh per annum.
• Mahesh gets tax benefits on the principal as well as interest payments.
• At the same time, he has to bear annual maintenance charges of Rs 24,000 (approx.) for the flat.

Taking all these into account, the net average monthly outflow for Mahesh would be -

The money used for down payment will earn interest, but that is considered later.

Comparing the rent and buy outflows

Now, Mahesh has calculated his monthly outflows in the both rent and buy 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 10%

The data shows that initially the outflow for buying is high, but it remains the same for the entire duration, while a rising curve can be seen in the case of the rent outflow. This means, initially the rent outflow is low compared to the buy outflow, but after some period, say 5 years, they converge at a point, and thereon we see a rise in the rent outflow.

B) When interest rate shoots up to 12 per cent

Let us assume that the interest rate goes up to 12 per cent. This will mean that for a floating interest rate, the EMI will also increase unless the tenure in increased. In this case, the monthly outflow will be as shown in the table below.

Property appreciation (Rent vs Buy)

The flat Mahesh will be buying will also act like an investment and generate an annual return as property prices move up. Let us sum up the outflow and gains for Mahesh:

Outflow

• Down payment of Rs 4 lakh
• Rental deposit of Rs 1 lakh
• Interest paid on the loan at 9 per cent

Gains/investment

• Appreciation of property value at 4 per cent over 20 years
• Tax saving in case of buying
• Interest earned on rental deposit

The chart below shows the overall Internal Rate of Return (IRR) generated by this investment for Mahesh over a period of 20 years.

* Annual Outflow = Monthly Outflow x 12 (See previous slide for monthly outflow values)

Here, we see that buying turns out a good proposition for Mahesh as he earns an implicit return of 15.49 per cent.
This return should be compared with other investment options like PPF, Mutual Funds, etc. However, it is advisable to go for at least one house of your own even if the returns are just moderate.

Evaluating risks to the returns in a house purchase

We have made some assumptions while calculating investment returns for Mahesh, 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 cent per annum. However, the same may not hold true in reality. Let us, therefore, look at the various returns that Mahesh might earn under different appreciation scenarios.

Risk 2: Change in interest rates
Mahesh did his calculation by keeping the interest rate constant at 10 per cent for the entire loan duration. But if the floating rate moves little 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 per cent p.a.).

Risk 3 – Change in annual rentals
The rental growth has been considered to be constant at 6 per cent 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 10 per cent and property appreciation, 4 per cent).

Summing it up

• Mahesh's rent is much lower than the EMI and other costs in the initial years, but it will later increase and surpass the EMI.
• Even though the EMI is higher, appreciation in the value of the property will make up for it.
• Property should be bought at the right time and for the right price. So for Mahesh, it will be a wise decision to buy the flat at Rs 20-25 lakh.
• 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 per cent increase in the EMI.

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