Modern society is presently characterized with skilled youth joining the workforce and earning incomes to make varied financial decisions. One significant financial investment is the decision to purchase a house. It is also one of the most common financial advices given by parents to their children. Most parents are convinced that owning a house is a rite of passage into adulthood. It is a belief that if someone buys a house at the early stage of their career, it helps them build equity and wealth, and then later they can sell the house for a bigger one or for greater value.
Instructions for purchasing a house is regarded as sound financial advice, which is often followed by individuals all over the world. However, instances have occurred which raised questions about the vitality of such a decision. This includes events like the subprime mortgage crises of 2008, general instability of the real estate market, and overall high purchase costs and debts. This raises the pertinent question of whether the purchase of a new house is a viable option or not. The rest of this article makes an attempt to address this statement of how effective it is to invest in the purchase a house.
Why the decision to purchase a house?
It is essential to first understand why people would show enthusiasm in investing the money to purchase a house. One major factor would be to save the money paid on rent. The opportunity cost of rental payment is the money foregone on other purchases, especially if one sees himself/herself in the same place for a long time. Instead of paying money on rent, the same money could be used for other purchases or payments.
Another factor is the appreciation of real estate. Even though the real estate market moves in cycles of ups and downs, real estate has always constantly appreciated. Many people thus view their home investment as a hedge against inflation. There thus exists a belief that there are greater returns on investment when purchasing a house.
There is also an emotional angle involved with the purchase of a house. There is the pride of ownership. This means one has the freedom to decorate and treat the house in any manner one wishes. Home ownership also gives a sense of stability and security to the person, as it is a form of investment in the future. This is one of the biggest factors that can influence a person to buy a house.
The Indian government is also trying to incentivize people to buy houses, which can be seen in the 2019 interim budget. The interim budget accords more benefits to home buyers. There is the income tax exemption which allows a person to save over Rs 28,000 annually if they have an income of Rs. 6 lakhs. With two earning members in the house, the annual savings are likely to increase by Rs 56,000 annually. This will benefit the affordable housing sector where the loans are usually priced at around Rs 10 lakh and an EMI of nearly Rs 10,000. There is also the exemption of tax on notational rent for second homes being put into effect, which can incentivize people to buy a second house. Lastly, there is the capital gains benefit. Earlier, a homeowner could save the capital gains tax on a sold property by reinvesting the amount into another property, but the guidelines did not allow him to invest the amount in two properties. As per the Union Budget of 2019-20, the benefit of rollover from capital gains under section 54 of the Income Tax Act will be increased from investment in one residential house to two residential houses for a taxpayer having capital gains of up to Rs 2 crore. However, this benefit can be availed only once in a lifetime.
Government programmes, like the Pradhan Mantri Awas Yojana, exist to make it easier for people to purchase houses and thus act as an incentive. This particular scheme aims to provide houses to every Indian citizen by 2022. Though the Union Budget 2019 decreased PMAY’s allocation from last year’s Rs. 26,405 crores to Rs. 25,853 crores, the government, nevertheless, introduced a dedicated fund for affordable housing to help banks and housing finance companies enhance their exposure in the affordable housing loan segment. This, in turn, will support the PMAY initiative and its implementation. All these factors are possible reasons why Indian citizens go ahead with the decision of buying a house in India.
Cost of buying a house
The cost of buying a house varies from one city to another. In Bengaluru it takes around 5.6 years at a savings rate of 25 percent of an annual pre-tax income of Rs. 8 lakh, and 10 percent expected return on savings, to be able to afford the down payment of a house, while it takes around 12 years for Mumbai and 3.6 years for Hyderabad with the same income and financial plan. It implies that the cost of purchasing a house varies depending on one’s location and city of residence. Further, it is obvious that not every type of house costs the same. A four bedroomed villa in the heart of the city, will not cost the same as a four bedroomed villa in the suburbs. The choice of the house and the locale depends on the aspirations of the buyer. The aspirations of the new buyer of a house stands out as a form of self-expression and not just property that he can afford, as stated by Adhil Shetty, the CEO of BankBazaar.com. In fact, the rising income levels and the easy access to credit fueled by banks and housing finance companies, have helped in boosting these aspirations.
To buy one’s dream house requires a stretching of one’s savings. Banks only lend around 80 to 85 percent of the value of the property at the outset, and the buyer must still shell out a lumpsum amount for the down payment of the house, which thus ends up taking a big chunk out of his own life savings. A survey conducted by The Economic Times found that one out of every three Indian homebuyers is sinking in more than 50 percent of his total savings into the down-payment itself. There are also further costs made after the down payment like the EMI, ancillary costs, property tax, home insurance premium, maintenance charges, utility bills, repair costs and interior decoration costs to name a few. This means that a rise in one’s costs with income remaining the same can potentially put the homeowner in a debt trap.
Is this worth it?
A single piece of real estate will inevitably constitute almost 70-80% of the buyer’s portfolio. A portfolio should consist of a group of assets with each asset having its own unique return, not correlated with that of another asset. Since houses are quite expensive, it would take up a greater space in one’s portfolio as compared to other assets, increasing overall risk and reducing returns for the person, which can affect his other financial goals.
There is also the misguided belief by homeowners that it is easily possible to sell the property and get full value for the asset. However real estate is not high on liquidity and the market fluctuates very easily with respect to bubbles and crashes, making it difficult for sellers to find buyers willing to take the house at the desired price. It is not convenient to liquidate real estate and hence the investor should have enough liquidity/ liquid assets to meet other financial goals with respect to contingency. Property is also not divisible, which means it is not possible to sell off a portion of the real estate.
Further, a rise in the value of a property might not always occur; hence it is not wise to commit to high home loans based on this expectation. Market corrections are inevitable as was seen with the 1997-2002 period when housing prices dropped more than 40-50 percent in Mumbai, even as some other regions remained relatively unscathed.
Let us not forget the issue of deserted construction projects. People who buy houses under construction still face high risks as there is possibility for extensive delays in handover and projects being left incomplete due to severe cash crunches.
Paying so much money for the house means that one’s real savings are much lower. This means less financial security for the person. According to research conducted by financial advisors, almost 28 percent of Indians are willing to allocate more than 40 percent of household income to home loan EMI with one out of two homebuyers willing to pour more than 50 percent of total savings in their down payment.
Is renting a better option?
No doubt, renting can be quite an appealing option. Paying rent does not mean throwing money away but is rather a method of opportunity which involves flexibility of mobilizing wealth. In other words, rent allows for greater mobility. When the economy stalls, people can be stuck in a particular location because of the house they have purchased, but if it is given on rent, it allows the person to move to any location where the job prospects are better. In order to comprehend why renting can be a better option, let us consider a hypothetical scenario. Let us say you decide to buy a house, which requires you to put down most of the liquid assets for the down payment. You decide to put around 20 percent of assets for it, which means there is still enough for an emergency reserve fund available even with mortgage payments, house insurance, taxes etc. But if there is a sudden job loss, you lose the job and income source. You end up eating into the emergency fund, which makes you more conscious about the house payments and financial security. It’s a possibility that the economy is terrible and jobs are scarce. Further, you are reaching a scarcity of funds that could trap you in debt. Even though you planned for this crisis, purchasing a house can still leave one in debt as the future is uncertain.
Purchasing a house usually requires a big investment and many people end up stretching their budget towards it. Also, at times it may not be the best option financially. This can force you to compromise on other aspects of family life. In addition to this, it is difficult to rebuild one’s savings in the future as compounding takes time. Further, the opportunity cost of using savings to purchase the house could mean lower funds for your child’s education. However, this does not mean one should never buy a house, but rather that one should be pragmatic in the approach. Potential homeowners should buy homes they can easily afford in a project and location that easily meets their needs for at least five to six years, and trade it later when they can afford better homes.
One should also be well-informed about market conditions, property prices, and rates of appreciation. Also, one should try to ensure that the EMI is less than 30 – 40 percent of their income as anything more could spell disaster. Being clear about finances and knowing how much one has in hand, the amount of loan one is eligible to apply for, and the amount of interest one would be able to bear with is imperative. One should also not forget to factor in the costs associated with buying a home, which includes transaction costs such as registration and stamp duty charges, brokerage, due diligence fees, transfer and mutation charges, documentation fee and the processing fee. If anyone keeps these basic lessons in mind, purchasing the house will become a viable investment instead of a financial suicide.
Picture Courtesy- Wall Street Journal