Turn Purchase of Your Dream House into a Successful Investment
In general, buying a dream house in a Metropolitan or Tier 1 city is considered an important milestone in the personal journey of middle-class and upper-middle-class Indians. However, with the rise in salaries and living standards, dream houses keep getting upgraded as one gets older. For most Indians in their late 20s and 30s, a dream house would always be a stretched investment, and there would never be enough money in the bank account to cover the entire payment.
The good news is that banks offer home loans of values equivalent to 75%-90% (depending on loan amounts) of the property value to the potential homebuyers. The even better news is that as home loans are issued against property as collateral, credit risk is relatively lower than other borrowings. Interest rates for home loans are significantly lower than personal loans and commercial credit.
Add interest rate sops offered by the government of up to tax break on interest payment of INR 2 Lakh for a financial year and tax rebate under section 80C on principle component of EMI. A home loan looks like a sure winner for homebuyers.
Buying vs Renting
There is always a question regarding buying vs. renting. Unlike US and Europe, rental yields in India are pretty low at 2%-3%. For example, if a house costs INR 1 Crore, the annual rent would be INR 2–3 Lakh. If we ignore the inflation component linked to rent, time value of money, and interest component linked with a home loan, the simple calculation says that the house would start paying for itself only after 30 years (1 Crore/3 Lakh). That means that before completion of 30 years, home buying would not result in any net savings in terms of monthly income. Right??
However, decision-making is much more complex. Consider that you want to buy a property worth INR 1 Crore and you have INR 1 Crore in cash with you. Suppose you decide against buying and went for renting with rental expenses being INR 2 Lakh per annum. Let’s say you invest this INR 1 Crore of savings for ten years and pay an annual rent of INR 2 Lakh (with annual inflation of 4.5%) over the next ten years. After ten years, your corpus may reach the following levels after adjusting for rent payments:
- INR 1.09 Crore (if you invest in Savings Account at 3% post-tax returns)
- INR 1.54 Crore (If you invest in FDs at 6% post-tax returns)
- INR 2.34 Crore (If you invest in Stock Market at 10% post-tax returns and more importantly, everything goes well for you)
It looks like the rent option is a real winner even if we consider a possible and feasible scenario of INR 1.54 Crore in the case of FD investments. Not quite.
Real estate is not a depreciating asset like a car. Real estate is a well-recognized investment vehicle like gold. If you are not unlucky to be stuck with a corrupt builder or disputed land, real estate prices can appreciate sharply during periods of high economic activity and high inflation. It is not abnormal to expect property prices to increase by 100% every ten years. Though real estate is an illiquid investment and normally, the house which is one’s home, is not seen as purely investment asset.
However, it cannot be ignored that soaring real estate value boosts the net worth of property owners and adds considerable heft to wealth perception.
Considering the realistic expectation of an INR 1 Crore property appreciating to INR 2 Crore, buying a home does not look like a really bad option as it can provide substantially higher returns than fixed-return products like FD and Savings Account.
Considering that you are living in the house and not looking to sell it, you can wait for a longer period even if expected returns are late in materializing.
When you are taking a final call on buying vs. renting, keep the following points in consideration:
- It requires significant discipline to ensure that excess savings from opting for renting (against upfront payments or hefty EMIs) are directed strictly in full into investment vehicles. Generally, it is difficult to resist using extra in-hand cash on luxury items or European holidays.
- Both real estate and stock market returns are estimated at best. These investments can cause losses as well.
Upfront Payment vs Home Loan
Once you decide to go for a house, there is always dilemma around whether to use a cash balance or go for a home loan. Let’s return to the previous example. Consider that you want to buy a property worth INR 1 Crore, and you have INR 1 Crore in cash with you. If you decide to buy a house against cash, considering expected property appreciation by 100% in ten years, the net worth would be INR 2 Crore at the end of ten years.
However, let’s assume the scenario where you went for a home loan of INR 80 Lakh and made the remaining upfront payment of INR 20 Lakh in cash. For the said example, the long-term home loan interest rate of 8.5% is considered (readers would be interested in knowing that the present home loan rate is lowest in the history at around 6.5%) , and loan duration is ten years. Based on assumptions, you have to pay approximately INR 99,000 as EMI every month for the next 120 months.
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Assuming tax benefit on interest payment and tax slab of 20%, you would end up paying INR 1.11 Crore (INR 80 Lakh of Loan Principle + INR 31 Lakh of Loan Interest) after ten years to the bank. However, the person has INR 80 Lakh cash for investments. Based on investment choices, one of the following may be the total net worth of the person at the end of ten years:
- INR 1.96 Crore (INR 2 Crore Home Value + INR 27 Lakh Savings Account Returns — INR 31 Lakh Loan Interest)
- INR 2.32 Crore (INR 2 Crore Home Value + INR 63 Lakh Fixed-Deposit Returns — INR 31 Lakh Loan Interest)
- INR 2.96 Crore (INR 2 Crore Home Value + INR 1.27 Crore Stock Market Returns — INR 31 Lakh Loan Interest
Here, readers can observe that option of taking an 80% loan and investing a corpus of INR 80 Lakh in FDs provide higher returns than making 100% upfront payment (INR 2.32 Crore net worth against INR 2 Crore in case of 100% upfront payment). Moreover, considering that FD provide fixed returns without any risk (if done with Post Office or SBI, a long-term FD rate of 6% post-tax is considered), it provides a suitable alternative for investor not comfortable with stock market.
Even if one considers the best-case scenario in case of renting at a net worth of INR 2.34 Crore, buying a house at 80% loan and investing 80% upfront payment in FD represent a similar option at net worth of INR 2.32 Crore (if 100% appreciation in 10-year expectation holds).
Our analysis concludes that potential homebuyers must strive for the maximum possible loan component when buying their dream home. We would suggest certain limitations and considerations while going for a home loan:
- Your monthly EMI must not be greater than 45% of your monthly household income. A higher ratio can create cash flow problems for regular and exceptional expenditures.
- Your total debt level ideally must not be more than 50% of your total assets.
- You must always assume that you have to create a corpus for prepayment, which would force you to cut unnecessary expenditures and increase savings.
Final Word
Though FDs are typically safe options with fixed-returns, we would ideally recommend Nifty ETFs to potential and existing homebuyers who are planning to invest their prepayment or upfront payment corpus. On a 10-Year basis, Nifty ETFs have provided annualized after-tax returns of 10% with a probability of 80% in the last 15 years. Unlike the stock market, real estate market cycles are quite long.
It is quite possible that real estate depreciates for a 10-year holding period instead of appreciating (100% appreciation expected), and Nifty ETFs provide sufficiently high returns to cover for losses in house value. With higher returns provided by Nifty ETFs, following net worth can be expected assuming buying dream house worth INR 1 Crore with 80% loan and investment of upfront corpus of INR 80 Lakh in Nifty ETFs for different house values:
- House Value Appreciates by 100% in 10 Years — INR 2.96 Crore — Best Case
- House Value Appreciates by 50% in 10 Years — INR 2.46 Crore
- House Value remain same in 10 Years — INR 1.96 Crore
- House Value Depreciates by 30% — INR 1.66 Crore — Worst Case
As readers can observe, even the worst-case scenario with Nifty ETF investing is better than the base case FD investment scenario in the case of renting the property.
If willing, homebuyers can seek much higher return potential from diversified baskets of an equity portfolio and ETFs. Therefore, we recommend investors with a corpus of more than INR 10 Lakh seek services of professional investment advisors who can help maximize returns through a diversified mix of stocks and ETFs in line with risk capacity, risk tolerance, and life goals.
Elever is one such hybrid investment advisor that can help investors reach their investment goals through an end-to-end digital experience aided by human advisors.
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