Copied from ET - Thought of putting it in my blog - Good Financial Analysis on Home
Why buy a home when you can rent one?
It’s obvious, isn’t it—if you pay rent for years, you’ll have nothing to show for it in the end, but if you used that money to pay home loan instalments instead, you would be creating an asset. This was the question Tarun Banerjee was pondering. But he couldn’t shake off the suspicion that the truth may be more complicated. Tarun, aged 37, is a senior-level financial services professional, married with two kids. He’s had his eye on a threebedroom flat in South Delhi, costing Rs 60 lakh. He would need to pay Rs 10 lakh up front, and borrow the remaining Rs 50 lakh. The 20-year equated monthly instalment (EMI) for the loan worked out to Rs 51,610 per month. Tarun wasn’t worried about the EMI, though—he could afford it. But he wanted to do a spot of number crunching. So we did a comparison of how Tarun would fare if he bought the flat, and if he rented it.
THE BUYING SCENARIO
Most people consider buying a house because of the tax breaks: the interest component of the EMI, up to Rs 1.5 lakh, is exempt from income tax. The maximum you can save in the highest income tax bracket (33.99%) is Rs 51,000. As for the principal, the tax benefit under Section 80C of the Income Tax Act is lost if, like Tarun, you pay the principal from your Provident Fund and insurance.
Also, since Tarun would take a loan of Rs 50 lakh, he would need life insurance, to protect his family from liability in case anything happened to him. We suggest two term insurance plans of Rs 25 lakh each, for which he would pay an annual premium of Rs 9,000 for each. Why two policies? Because 15 years into the loan period, the amount pending repayment would be Rs 25 lakh. If he bought a policy each of 14 and 20 years’ duration, he would need only one policy from the 15th year.
The net cash flow (tax savings on the Rs 1.5 lakh deduction, minus insurance charges) would be invested in diversified equity mutual funds, and would grow to Rs 26.78 lakh in 20 years, assuming the mutual funds give a tax-free return at a compounded annual growth rate (CAGR) of 12% (a reasonable assumption, as equity has given 16% returns over a 26-year period, and the future looks even better)
I assumed a year-on-year growth of about eight per cent in the property value. Tarun was shocked: “Doesn’t it grow by 30-40 % year on year?” I explained my reasoning. If property grew at that rate, this property would be worth Rs 2.23 crore in just five years! Now, if you want to sell, there should be buyers, right? If someone was going to rely on loans to buy property, they may have to borrow Rs 2 crore, and fork out an EMI of Rs 2 lakh. Not many people can afford that. Salaries are growing on an average at the rate of 10-15 % a year, so rising incomes cannot take care of that. The explosive growth of the past three or four years is unlikely to occur again in the future. Some exceptional mutual funds have given returns of 800-1000 % over a five-year period, but that, too, is going to be difficult to replicate (this is why I reckon a 12% CAGR for mutual funds). Historically, too, property has grown at a sedate, single-digit rate. An 8% return thus seems realistic over a 20-year period. In fact, after deducting 0.5% for society charges, property tax, and so on, net growth would be around 7.5%. The property is likely to be worth Rs 2.55 crore after 20 years. The total corpus then would be Rs 2.82 crore. Tarun was underwhelmed.
THE RENT SCENARIO
What if he were to rent the same flat? The rental norm for prime residential property is 6% per year of the property value, so let’s assume that figure throughout the 20-year period, although it’s more likely to be less than 6%. Anyhow, we reckon Tarun would pay Rs 3.6 lakh as rent in the first year, with 5% annual increases in subsequent years. Since he could afford an EMI of Rs 51,640, he can easily afford this rent. The amount available after rent is invested in a mutual fund. At 12% CAGR, this would yield Rs 97 lakh in 20 years. Plus, we would put the Rs 10 lakh that Tarun would have paid up front to buy the flat in a mutual fund. This would grow to Rs 96.46 lakh after 20 years. Add to this the tax saving that Tarun would claim on rent. The tax-exempt amount would follow the one-in-three formula: either 50% of the basic rent declared by Tarun’s employer, or 10% of rent above the basic, or the actual house rent allowance . It is reasonable to assume Tarun would claim a deduction of 75% of total rent paid. The tax saved would also be invested in a mutual fund, and would amount to Rs.1.03 crore in 20 years. So the total cash flow is Rs 2.96 crore. The comparison The final corpus in both cases is not too different, right? Renting would leave Tarun with Rs 14 lakh more than buying his own place. Now, some might argue that comparing a cash flow with real estate is like comparing apples and oranges. So let’s see what happens if the whole corpus is converted to cash. If he bought the flat, Tarun would pay Rs 10 lakh as long-term capital gains tax. If he rented, he would pay not tax. So renting actually leaves him with Rs 24 lakh more. If we tweaked some numbers , the situation would still not be vastly different. The last I heard from Tarun’s wife, he was still looking at properties—to rent!
(The writer is chief financial planner, Ladder 7 Financial Advisories)