Should we buy a house or rent it : Let's understand the implications

In our fathers or grandfather time buying a house use to be the final priority generally when at retirement they want to settle-down. IN those days getting loan was not easy and the housing market was also not that much developed. But even today buying a house is a dream for young generation. However with property prices having gone off the roof, especially in a metro such as Mumbai, this primary need has actually became a distant dream. Even in extended suburbs prices are touching roof and its almost impossible for a middle class person to buy a home there. There is argument that buying a house is still a good decision as over the years the capital appreciation will make it profitable but how much true it will be a big question.

In Mumbai there is lot of unsold properties lying. The reason for which is:

·         property prices are unaffordable to the middle class;

·         Income not going in proportionate to the housing prices

·         Higher Interest rates making home loan costly;

·         Alternate investment options like equity market encouraging many to invest in equities

As we can see that the supply is outstripping demand especially in big cities like Mumbai. This limits the scope for capital appreciation in near future. As a result the property prices have stagnated.

However owing a house still is a very important factor for many of us in life. However it is very important for us to understand that the purchase of house can have big impact on our finances, wherein we may even have to compromise on some of the other long-term financial goals such as such children’s higher education, their marriage and even our own retirement needs. Therefore we need to weigh the pros and cons wisely. 

While buying a house carries many advantages such as stability of place, hedge against inflation, capital appreciation, diversification and rental yields; these benefits really don’t matter if we are looking out for a house to live in and not for investment purpose. For living in that house we should be more concerned with factors such as: 

Affordability – We all want to buy the best but we need to look at our income and litations while buying a house. We should understand that to own a plush home in a prime locality may affect our long-term finances if we fail to estimate our future income and expenditure. Hence proper budgeting should be the starting point of to decide upon the city or locality within a city where we can afford to buy the property. Generally our EMI-to-income ratio should not exceed 40% of the total household income. We should be very careful while availing home loan as EMI affects the cash flow in a big way as usually very less sum is left after having accounted for EMIs and expenses for investment purpose to meet other short and long-term financial goals.

Also while checking the affordability we should be taking into account the maintenance cost you would defray and proximity to other work place, commercial areas and other essential services which can reduce the cost and the time involved in travelling. 

Property exploration: Once we have calculated the amount we can afford to buy home, we should be doing background check considering the following nitty-gritties amongst host of other things...

• ·         Who is the builder?
• ·         Builder’s past track record?
• ·         Has he completed his previous projects on time?
• ·         The rate which he is offering for the amenities
• ·         Prices of similar properties in same locality
• ·         We should also visit the site and check the quality of construction
• ·         WE can also visit the other properties of the same builder to check the ground reality regarding his promises
• ·         To check with the title and all other statutory permissions
• ·         If the constructions is still going on then what would be the time lag for getting the possession
• ·         If the property is ready for possession i.e. newly constructed or a resale property; then the age of building and has a society being formed
• ·         Is the project and builder are approved by the banks for loans
• ·         Quality of Construction

As we all know that - buying a house and renting one both, have their own unique set of costs and therefore it is very important to evaluate both to make a prudent choice. The following illustration here would help you get better insight.

Mr Mehta is salaried individual placed in Mumbai drawing a basic monthly salary of Rs 50,000 falling under the highest tax bracket.  

Mr. Mehta, lives in Mumbai Suburbs
Gross Monthly Salary (in Rs)	125,000
Basic Monthly Salary (in Rs)	50,000
Monthly HRA (in Rs)	15,000
Assumptions:
Tax Bracket	30.90%
Annual increment in salary	10.00%
Tax laws remains same for next 20 Yrs

He is exploring two options-

1. Staying in a rented accommodation; or
2. Buying a house to live in availing a home loan

Option 1- Staying in rent for 20 Years
Tenure of residency (Years)	20
Rent per month (Rs.)	15,000
Annual rent (Rs.)	180,000
Initial Deposit (Rs.)	150,000
Increase in Rent (P.a)	8%
Result:
Total expenditure on rent (over 20 years) [i]	9,462,305
Tax benefit on house rent (over 20 years) [ii]	5,491,436
Loss of interest (@8%) on initial deposit (over 20 years) [iii]	549,144
Total expenditure on rent after accounting for tax benefits (i-ii+iii)	4,520,013

Now suppose, if he opts for living in a rented house where he will pay a monthly rent of Rs 15000/- along with an initial deposit of Rs 150,000 (refundable once he vacates the house) and assuming he stays there for 20 years and is subject to an annual escalation clause of 8% for rent; over the tenure of residency (i.e. 20 years) he would be paying a sum of Rs 94,62,305/- on rent. However, as per Section 10(13A) of the Income Tax Act, he is entitled to a tax benefit for House Rent Allowance (HRA). Therefore, over the 20-year period he is estimated to receive a tax benefit of Rs 54,91,436. Also we’ve considered the loss of interest, which he has to bear on the initial deposit doled out, as that’s the opportunity he has foregone whereby he could have invested the same sum and earned an interest of Rs 5,49,144 assuming it remains same @ 8.0% p.a. for the whole tenor.

Taking into consideration all these aspects, i.e. his expenditure on house rent, the opportunity loss and the tax benefit he would receive, the net expenditure for renting the house would amount to Rs. 45,20,013/-.

Now say he explores the second option i.e. to buy a house to live in availing a home loan...

Option 2- Buy home by taking home loan
Cost of the house	8,000,000
Loan amount	6,500,000
Tenure of loan (Years)	20
Rate of Interest for Home Loan (%)	9.75
EMI (Rs.)	61,654
Monthly Maintenance Cost (Rs.)	1,500
Initial payment:
(a) Personal contribution	1,500,000
(b) Stamp duty & Registration (6% of property cost)	480,000
Total initial payment (a+b)	1,980,000
Outcome:
EMI outgo (over 20 years) and initial payment [i]	14,796,960
Tax benefits received from EMI (over 20 Yrs) [ii]	6,566,512
Maintenance Cost (growing by 5% annually) [iii]	889,612
Loss of interest (@8%) on account of initial payment (over 20 years) [iv]	7,248,695
Total expenditure after adjusting for tax benefits [i-ii+iii+iv]	16,368,755

Here with the aforementioned details on the cost of the house and loan he would avail, his initial contribution (including the stamp duty and registration) would be Rs 19,80,000. Also over the tenure of the loan of 20 years, he would pay an EMI per month of Rs 61,654. Including the initial payment and EMI his outgo over 20 years would be Rs 1,67,76,960. However since he has availed a home loan, he would be entitled to a tax benefit under Section 80C and Section 24(b) of the Income Tax Act, 1961 together amounting to Rs 65,66,512 on the EMI paid over the tenure of the loan. Also like in option 1, here too we have considered the loss of interest on the initial payment of Rs 19,80,000 which could have otherwise earned him interest amounting to Rs 72,48,695 had he invested in an instrument offering a steady rate of interest @ 8.0% p.a. He would also require to pay monthly maintenance cost which is assumed at Rs. 1500/- first year growing by 5% annually.

After taking into consideration all the aspects such as total home loan repayments, tax benefits, maintenance expenses and the opportunity loss, the net expenditure on buying a house would have amounted to Rs 1,63,68,755. 

The comparison between option 1 and option 2 reveals that over a period of 20 years staying on rent is much cheaper (Rs 45,20,013) as against buying a house by availing a home loan (Rs 1,63,68,755). However we have not considered the future sales value of the house in this calculation.

However these numbers can change if the scenario or assumption differs.  Therefore it is imperative to take understand the environment in the property market while taking the decision of buying a house or living on rent. 

Further as we all know that in India buying a house is filled with emotions, and more so, when one is moving in with a family, making it a home. Our own house also gives a stability  which can never be in case of a rented home. So while we wish to buy our dream home, we should account for not just financial factors but also the non-financial factors (individual needs and aspirations), to make the a prudent and feasible choice for your and family’s well-being. 

The basic terms regarding debt investments

Like in food we need all the variants (i.e. Rotis, vegetables, pulses, salads etc.) so as to get all the necessary things for our developments similarly for investments also we should have all type of securities i.e. equity, debt, gold real estate so that we can get the best out of it. Although debt securities are viewed as the least interesting component of a portfolio, lacking the vitality of stocks and equity instruments. But it performs a useful function in a portfolio, and it would be sensible for investors to have basic understanding of them, in this post we are discussing the basics of debt securities.

Yield  

A Debenture / bond's coupon is the annual interest rate paid by the issuer of the security. It can be paid out by various frequency depending upon the terms of the security i.e. quarterly, semi-annually or annually. The coupon is always linked to a bond's face value.

Say you invest Rs 10,000 in a 5-year bond paying a coupon rate of 8% per year, semi-annually. In this case, you will receive 10 coupon payments of Rs 400 each over the tenure of the bond.

Bonds that don't make regular interest payments are called zero-coupon bonds, in which they don’t pay interest in between the tenure of the bonds. Investors buy such bonds at a discount to the face value of the bond and are paid the face value when the bond matures.

Say we invest Rs 10,000 Face Value bond having maturity after 5-year bond at a discounted value of Rs.7000. In this case the annualised yield comes to approximate 7.40%.

Companies also issue floating rate bonds where the interest rate is linked with some benchmark rates and it fluctuates as the benchmark rate moves.

Yield is different from the coupon rate.

Let’s say a bond has a face value of Rs 100 with and 9% coupon rate. This means that the investor will earn Rs 9 per annum on each bond he invests in.

Once the bond is issued, after that, it trades in the open market – meaning that its price will fluctuate each business day for its entire life depending upon various economic and market related factors. As interest rates in the economy rise and fall and demand for the bonds moves up and down, it will impact the price of the bond.

Let’s assume interest rates rise to 10%. Even so, the investor will continue to earn Rs 9. That is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 90 {9/90= 10%}.

Now let’s say interest rates fall to 8%. Again, the investor will continue to earn Rs 9. This time the price of the bond will have to go up to Rs 111.29 (approx.) {9/111.29= 8%}.

This explains two aspects from the above examples.

·     One is that the yield is not fixed but fluctuates to changes in the interest rate.

·     Secondly, the price of the bond moves inversely to interest rates. It moves to maintain a level where it will attract buyers.

Yield to Maturity

The Yield to Maturity, or YTM, of a debt fund portfolio is the rate of return an investor could expect if all the securities in the portfolio are held until maturity. 

For instance, if a debt fund has a YTM of 9%, it means that if the portfolio remains constant until all the holdings mature, then the return to the investor would be 9% (annualised). This is generally applicable to Fixed Maturity Plans of Mutual funds.

However, in the practical world and especially for open ended mutual funds the YTM does not remain constant as the portfolios are actively managed by the fund manager.

YTM broadly indicates to the investor the kind of returns could be expected. But it is not a definite indicator since returns may vary due mark-to-market valuations or changes in the portfolio.

Modified Duration

Modified Duration, or MD is the number which can further elaborate the point that bond prices and interest rates are inversely related.

As explained earlier, if there is a rise in interest rates then there is a fall in the price of the bond. If there is a fall in interest rates, then the price of bond will rise.

MD is the change in the value a debt security in response to the change in interest rates. So let’s say the MD of the bond is 4. Then it indicates that the price of the bond will decrease by 4% with a 1% (100 basis point, or bps) increase in interest rates.

This provides a fair indication of a bond’s sensitivity to a change in interest rates. The higher the duration, the more volatility the bond exhibits with a change in interest rates.

When we consider the modified duration of a portfolio, It means that it takes into account all the debt instruments and will change with regard to the composition of the portfolio.

Credit Rating

All bonds/debentures are not equal and it is measured by the credit rating of the issuer company. There are five credit rating agencies approved by SEBI to rate the companies. The top rating for any security is AAA and it goes down to AA, A, BBB and so on. Generally the investors’ grade rating is upto BBB.

Higher the rating means stronger the issuer company which indicates lower the risk so the interest rate offered by the company will be lower as compared to the lower rated companies. Sovereign bonds issued by the government are generally called as risk free securities and considered as benchmark while comparing the risk return trade-off with other issuers.

At Retirement: Can we take care of ourselves??

Our country’s significant populations has no social security at the time of retirement and old age. It is far, far away from the bliss and happiness everyone hopes for in this phase.

In India: Retirement – not so golden for many 

Various studies based on the last national census (2011) suggest that about 60-70% of the aged in the country had to depend on others for their day-to-day maintenance. The others here are generally their own children; spouses, grandchildren and sometimes even non-relations included. Moreover, of those who had the fortune of being economically independent, 90% had to support one or more dependents.

Like the old internet joke comparing human life span with animals goes, for the first 20 years of our life we eat, sleep, play, and enjoy ourselves. For the next 40 years we slave in the sun like a donkey does, to support our family. For the next 10 years we do monkey tricks to entertain the grandchildren. And for the last 10 years we sit on the front porch like dogs do and watch others go by their lives! Old age is supposed to be that part of one’s life which is care-free, holidaying, spending time with the grandchildren, doing things one always dreamed of in their hurry-worry-filled work phase.

In keeping with the global trend, life expectancy of India has been rising over the years. It was around 66 years in 2010, and retirement age varies in different sectors, ranging from 52 years to 65 years. But this blessing of rising life expectancy translates to another unfortunate trend: the proportion of the oldest elderly (aged 80 years and above) among the working population is relatively high in India compared to many other countries. A majority of the elderly work due to economic necessity and not out of choice or chance. And of course a majority of these elderly workers are self-employed because employers do not prefer them due to their declining state of health and energy.

Almost 85% are not covered! 

In India only a few fortunate seniors have pension, the rest has neither pension nor savings of their own. Figures point out that only about 10-15% senior citizens, most of who have been in government service are entitled to pension. This means that roughly 8 out of every 10 non-working senior citizen in the country gets no pension. The statistics is better for retirees in the urban areas but only slightly; about 16% senior citizens get pension compared to 10% in the rural areas, according to a UNFPA report.

The scope of pension is seemingly limited to government jobs alone hence it is not a surprise that so few senior citizens earn pension. Private sector employees in the organized sector have the Employee Provident Fund (EPF). However the organized sector represents only about 10-15% of India’s total working population. The overwhelming majority of the aged Indians has been employed in the non-organized sector, where employment conditions are poor and is reflecting in pitiable post-retirement benefits.

So where do we stand?

Do we have any idea that how much money would be required to maintain the current lifestyle after our retirements? Lets look at it more logically and mathematically: If we are in our 30's and presently live on a modest Rs 20,000 per month budget (EMI's excluded) then this would transform to more than Rs. 1.43 lakhs even if we take inflation at 5%. And if the inflation goes up by just 2% to 8% the expenses will go up by almost double to Rs. 2.51 lakhs by the time we retire after 30 years. The table given below may give much better idea on this

When we see the figures we stop thinking on where we are on our own journey to retirement. Generally most of us dislike thinking of ageing, forget preparing for it…However there is a way to tackle this situation more intelligently, and with a little bit of planning and efforts retirement could be an extended holiday that we actually look forward to! 

So how to do it?  

Most of of us are employed in the private sector, there we would have to patiently build the old age nest egg by ourselves. But this could be a blessing in disguise as we have the liberty to invest our savings wisely rather than being compelled to park retirement savings in fixed income financial products whose yields are comparatively lower than growth assets. As for those employed in the government sector that may have some form of pension to fall back on during their golden years, in all likelihood such pension alone would barely be sufficient to see them through. They too would have to invest for building a sufficient retirement corpus.

Now regardless of which group of the two we belong to, we can confidently aim at gifting ourself a generous self-made pension by investing systematically in mutual funds. Here is a suggested investment guide for building your retirement corpus with mutual funds.

Years to retire	Suggested investment
5-10 years or more	Equity funds with combo of large, mid and small cap funds
Less than 5 years	Balanced Funds with some part in large cap funds

The most important point here is to start as early as possible. For an illustration, suppose that at 30 years of age you begin building the corpus with a monthly allocation of Rs 7,000 earning a 13% yearly return, at 60 years you would have accumulated about Rs 2.63 crores. What if you delay by just 3 years? This corpus would be short of almost Rs 83 lakhs; i.e. your end corpus would be around Rs 1.80 crores.

Mutual funds offer a standardized option for making monthly investments in any given fund and this is called by the name SIP or Systematic Investment Plan. Start an SIP as suggested in the table above and consider retirement investment as a mandatory deduction similar to our old investments called as PF! But remember that ultimately our choice of investment should depend on factors such as risk appetite (which is a function of our age to an extent) and asset allocation needs. Hence also consult a Financial Expert so as to select the most suitable choices for your goal.