“Home loan interests at a 15-year low”- is one the most lucrative headlines of recent times. As India saw new lowest records being made with the housing loan interest dropping to as low as 6.95% for SBI (for a loan < 30 Lakh) in Mar’21, Ramesh also toyed with the idea of making the most of the opportunity. Buying a second house has been on the agenda for quite some time now. Ramesh thinks this is the best time to buy a house if you can lock in at a lower interest rate, and it will also help him with the rental income
Ramesh is enticed by the same numbers that have been probably attracting you in the reports recently. Moreover, reports suggest that the real estate prices have been correcting and have dropped by up to 9% for the top 8 Indian cities. Simple right? Let’s buy a cheaper house at a more reasonable interest rate while the offers last! But is it that simple? Do the numbers add up? Or is Ramesh just influenced by the generations-old lure of investing in real estate? Let us find out-
Ramesh is not basing his decision on the emotional argument about how having multiple real-estate properties is a boon for his next generations. His logic is based on numbers.
Who minds the passive income, especially if it helps you pay your EMIs and build an asset for yourself, right? That’s what Ramesh also thinks. Buying the second house and letting it out is a common practice.
Ramesh lives in Gurugram, and the house he is eyeing will cost him Rs 80 Lakh. Now, the price-to-rent ratio is which is the percentage of the property’s price you can get as rent in Gurugram is around 41.67 annuall8. Hence on the property of Rs 80 lakh, Ramesh calculated he will get Rs 16,000 as monthly rent.
|Cost of the property (A)||₹80 Lakh|
|Price to rent ratio in Gurugram (B)||₹41.67|
|Expected rental income per annum (A/B)||₹1.91 Lakh|
|Expected rental income per month (approx)||₹16,000|
Now, Ramesh will take a loan of Rs 50 lakh to fund this house purchase. Considering he applies for a home loan of Rs 50 Lakh and an assumed fixed loan interest of 6.75%, his monthly EMI comes to around Rs. 38,000
|Loan Amount||₹50 Lakh|
|Loan Tenure||20 years|
|Equated Monthly Instalments||₹38,000|
With the rent of Rs 16,000 coming as rent, Ramesh calculated he will need to pay just Rs 22,000 extra every month and he will build a property. With him and his wife working and having stable jobs, that amount is manageable for him.
He also assumed and rightly so that the rent will grow at an average of 5% every year. So his total extra outflow over 20 years will be around Rs 27 Lakh or an average of Rs 11,564 every month.
|Total Loan repaid in 20 years (A)||₹91.2 Lakh|
|Total rental income in 20 years (assuming 5% rent increment every year) (B)||₹63.48 Lakh|
|Net outflow over the rental income in 20 years (A-B)||₹27.75 Lakh|
So, in effect, a property that was costing him Rs 1.21 Cr (Rs 30 Lakh down payment + Rs 91.24 Lakh loan repayment), is effectively costing him Rs 57.75 Lakh considering the rent inflow of Rs 63.48 Lakh.
As the rent appreciates, so will the value of the property. As most of the societal development moves towards the outskirts of the cities, a house bought in an area that is sparsely populated right now can be a good bet. Buying a house is not a short-term investment for Ramesh, as he wishes to hold it until retirement.
The average return that a real estate investor got from his investment in the area where Ramesh is looking to invest in, in the past few years is 7-8%. Ramesh is assuming that the same increment in the property value will continue for the coming years as well. Based on this assumption, here is what Ramesh figured will be his overall return
|Current Value of the House||₹80 Lakh|
|Expected Value of the House after 20 Years (assuming 7% price appreciation)||₹3.1 crore|
|Money Paid by Ramesh to acquire this asset (Downpayment+ Difference between Rent and EMI)||₹57.75 Lakh|
|Expected Returns per Ramesh||₹2.52 Crore|
A neat Rs 2.5 crore from an investment looked pretty good to Ramesh. What further convinced him was all the tax benefits he could avail when he took a home loan.
There are two sections in the Income Tax Act, 1961 under which Ramesh can claim tax deductions- Section 80C and Section 24B. Each EMI that Ramesh pays has a component of the principal amount and interest amount. For example, for the first year of his loan payment, Ramesh shall pay Rs 38,018 for 12 months, i.e., ~ Rs 4.56 Lakh. Out of this amount, the principal amount is Rs 1.22 Lakh, and interest is Rs 3.33 Lakh. Also, for the first year, he can include the stamp duty and registration charges under deduction, as well. While the principal repayment, Ramesh can avail a maximum tax benefit of Rs 1.5 Lakh in an FY. The rent from the second home will need to be declared as part of his income, and he can avail a 30% tax benefit on the loan interest. He can also claim up to Rs 2 Lakh against other sources of income.
Buying houses for most of us has a very high aspirational value. But the primary question that arises is that why should any investment be costing them money? Investments are made to secure your future. By paying interest rather than earning it, we are losing out on better investment opportunities. Let us look at Ramesh’s points again, but in a different light.
There are two factors that Ramesh and many investors tend to forget when calculating income from the rental property. Firstly, he will have to pay tax on the rental income. Since Ramesh is in the highest bracket, that means 30% of the rent will go as tax thereby reducing the rent in hand. And secondly, as the owner of the house, he is liable to pay the monthly maintenance of the house as well, which is easily 20% of the rental income.
Keeping these two additional expenses in mind, let’s relook at the numbers So, trying the same calculations again-
|Total loan repaid in 20 years (A)||₹91.24 Lakh|
|Total rental income in 20 years (assuming 5% rent increment ) (B)||₹63.48 Lakh|
|Tax paid on the rental income in 20 years (C)||₹19.04 Lakh|
|Maintenance charges for 20 years (D)||₹12.69 Lakh|
|Net outflow above the rental income (A-(B-(C+D))||₹59.49 Lakh|
As you can see, the actual outflow over 20 years for him will be Rs 59.49 lakh which is more than double his estimate of Rs 27.75 lakh. As a result, his actual cost of owning the asset will be Rs 89.49 Lakh and not Rs 57.75 lakh.
Even though Ramesh is assuming that the property will grow at 7-8% per year, the fact is that with a huge unsold inventory of houses, especially in the metros and low demand, the growth has been very nominal at hardly 4% on an average and going as low as 2.8% in 2020.
While 2020 was an exceptional year, there is enough data that indicates that real estate prices have been almost stagnant for a few years and there are bleak chances this will change in the near term. However, even if we take an optimistic view and assume Ramesh will get 6% annual appreciation, his final returns after adjusting for everything won’t be great.
|Current Value of the House||₹80 Lakh|
|Predicted Value of the House after 20 Years (assuming 6% price appreciation)||₹2.56 crore|
|Money Ramesh will actually end up paying to acquire the asset||₹89.49 Lakh|
|Returns from the Property||₹1.66 Crore|
As you can see, over a period of 20 years a Rs. 1.66 crore net again is not a very impressive number. But that is just one of the reasons for Ramesh to reconsider this.
Ramesh is assuming that the interest of 6.75% will remain constant, which is not the case practically. Very few banks/NBFCs offer fixed home loan interests these days, and hence, the possibility of you locking in on a low interest rate is slim. Instead, the interest rate may be floating in nature. As the interest rate increases with time, so will either the loan tenure of 20 years or EMI.
If you can’t afford an increase in EMI and go for a loan tenure increase, that would mean paying even more interest because you will be paying it for a longer period, depending on how much the tenure increases. That will also mean paying off debt even after you have retired. That is just an increased liability.
Firstly, the Rs 1.5 Lakh deduction under section 80C of the Income Tax Act, 1961, can include the stamp duty and registration charges, etc. but only for the first year. This is a deduction you can easily cover with your other tax-saving investments like ELSS, PPFs, etc. Secondly, since most of the interest is paid to the bank in the first few years of the loan tenure, the benefit under section 24B considerably reduces as years go by. Also, if Ramesh buys property under construction, these deductions only apply if the construction is completed within five years. If not, then the interest deduction is reduced to Rs 30,000 only.
A real estate property is not a stock that can be sold on the stock market any day. It takes time and effort to sell off a real estate property. You can’t sell a room of your property; you will have to find a buyer for the whole house. The investment they make should help them in emergencies and not become a liability with time. Buying a house in which you are, in all possibility, not going to live in, and may also require a lot of leg-work in terms of selling, may not make sense.
Whether you let out the house or not, maintenance must be paid every month. Also, the hassle of finding the right tenants, ensuring that the rent comes in on time, and keeping the house in a decent condition is a bit too much. What if the tenants change every 6 months? Then the same agreement paperwork will have to be redone each time a new tenant moves in. At the same time, the upkeep of the house between tenant switches is your responsibility.
Considering all the factors above, do you think Ramesh’s decision to buy a second home is a good one? If not, then what choices of investment avenues does he have that will give him the desired returns? Let us find out.
If Ramesh is looking for a long-term investment with returns that can help beat inflation, he can consider Equity Mutual Funds. Equity investments are likely to be volatile in the short term and are ideal for a long-term investment like Ramesh’s. They can assist in wealth creation and even retirement planning.
Compared to real estate, mutual fund investments do not require you to take a loan or pay interest. They also do not require huge down payments and can be started with an amount as low as Rs 500. They don’t come with additional hassles or overheads. The last and the most important point- what are the returns generated by equity mutual funds?
Now, Equity Mutual Fund returns being market-linked may fluctuate in the coming 20 years, which is Ramesh’s investment horizon. So, let us assume an average return of 12%, on the more conservative side.
If Ramesh invests Rs 30,00,000 (the down payment amount) in each of these categories for 20 years and Rs 24,791 (additional EMI outflow) as a SIP, let us see what their returns will be like-
|Category||Maturity amount for ₹30 Lakh lump sum investment||Maturity amount for ₹24,791 SIP after 20 years||Total amount after 20 years|
|Equity Mutual Fund||₹2.89 Cr||₹2.47 Cr||₹5.37 Cr|
To compare, the investment of Rs 80 Lakh in the property, assuming 6% returns, would have grown to ~Rs 1.66 Cr only, whereas the same investment has the capability of growing to Rs 5.37 Cr with equity mutual fund schemes. The difference will be much wider because when Ramesh sells his house 20 years hence, he will also pay Long Term Capital Gains tax on it, thereby reducing the income further. This, with added liquidity and no hassles of maintenance in equity mutual funds, is a no-brainer.
Asset diversification is an important aspect of investing. It is wise to diversify your money amongst various assets like equity, debt, gold, real estate, etc. But over-diversification may also come with its own set of challenges, as seen above.
Also, there will always be something lucrative making headlines, but you ought to weigh all the pros and cons and make an informed decision rather than jumping at every opportunity you get. Always remember, you are unique; what works for someone else may not work for you. Follow your own path to financial freedom.