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FISCALLY FIT

Your first ‘dream home’

BY SHYAM P.

Buying your first home just to save on rent or to get tax benefits does not make financial sense. Mutual funds are a better option.

Photo: S. Mahinsha

Not a sound investment: Look elsewhere for higher returns.

I wanted to avail of a home loan but decided against it as I have seen people struggle a lot to repay their loan. Though I feel that there are tax incentives one can make use of, I would like to know what are the parameters involved in deciding to buy a home.

S. Rajendra Babu

The key reasons for a middle class family to buy a home are: a. To have the security of a roof above one’s head; b. To save rent; c. To save tax; d. To buy an asset that has the potential for appreciation in value. Let’s do a dispassionat e analysis of why and when it would actually make sense to buy a home.

The minute you take out a loan (which most families do to buy a home), the first argument loses sense. Come on! When you are taking a loan — usually in the order of 20+ Lakhs — it is by no means going to offer you any immediate mental security, even if your missus and your father-in-law suddenly become proud of you.

Let’s say you continue to rent, in case you don’t buy a home. Then you will be servicing a rent yield of maximum five per cent. Rent yield is defined as the annual rent as a percentage of the value of the home. The average rent yield in metros is a little less than 5 per cent and it falls further in tier-two cities.

How about home loan as a tax saver? The IT Department allows an annual deduction of Principal Repayment of up to Rs. 1 lakh from Gross Total Income under Sec. 80c of the IT Act. If the property is self-occupied (which I assume it will be, if it is your first dream home), Rs. 1.5 lakhs of the annual Interest Repayment can be deducted from Gross Total Income under Sec. 24 of the IT Act. If you can avail of the entire 2.5 lakhs deduction, the actual tax savings works out to 33.99 per cent (marginal tax rate at the highest tax bracket including surcharge, cess) of Rs. 2.5 lakhs, which is Rs. 85,000 approximately..

Marginal savings

Unfortunately, because of the amortization schedule of a reducing balance home loan, either the principal repayment will work out to be less than one lakh or the interest repayment will be less than 1.5 lakhs during most years of loan tenure. This will reduce your actual tax savings to Rs. 75,000 a year, which works out to 1.8 per cent p.a for a 40-lakhs apartment. And, you can anyway get the one Lakh 80C deduction with tax-free capital appreciation potential by investing in ELSS schemes.

The question is: should you buy a home just because you get to save on rent and get a tax incentive? Let me try to answer using the concept of “opportunity cost” through the example of two gentlemen: Ram, the home guy and Shyam, the mutual fund guy (no reference to yours truly whatsoever). Both happen to be neighbours in a new apartment block.

Ram owns his apartment that is worth Rs. 40 lakhs with the following terms: Equity down payment: Rs. 8 lakhs, Loan amount: Rs 32 lakhs @ the interest rate of 11 per cent p.a (variable), repayment tenure: 20 years, EMI: Rs. 33,030 per month. Annual tax savings, Rs. 75,000 (refer workings above)

Shyam is scared of debt (not me again) and therefore rents the apartment adjacent to Ram’s, paying a monthly rent of Rs. 16,000 (approx 5 per cent the value of the home). His landlord has said that he will raise the rent by 15 per cent every three years. Since Shyam does not have to make the down payment on a home, he decides to keep his nest egg of Rs. 8 lakhs invested in a blue-chip broad-based mutual fund that has given him over 20 per cent p.a returns in the past. Since he is conservative, he expects to make not more than 15 per cent p.a over the next 20 years.

Shyam has heard about his friend Ram allocating Rs. 33,030 every month towards a home loan; as a practical experiment he decides to invest an amount equal to his friend’s EMI minus his own monthly rent in a mutual fund. The only thing is that he has to forgo the 1.5 Lakh tax deduction on annual interest payment that his friend Ram can avail of. But he consoles himself with the fact that he can still get the Rs. 1 lakh 80c tax deduction from the ELSS scheme in his mutual fund.

Rich rewards

Let’s fast-forward 20 years from now. Shyam’s initial nest egg plus the monthly investments in mutual funds are worth Rs 2.2 crores! (at 15 per cent p.a average returns) To match this, the apartment that Ram owns should appreciate in value by 9 per cent per annum, i.e the value of the home must double every eight years. In fact, if the interest rate on the loan that Ram had taken (originally at 11 per cent p.a) increases to 15 per cent p.a, then the home has to appreciate in value by 11.5 per cent p.a (i.e., the value of the home must double every six years) to catch up with Shyam whose net worth on directly investing the higher EMI amount in mutual funds would reach Rs. 3.4 crores.

This is a clear indication of the fact that one cannot buy a home merely for the tax savings or the rent savings. The key decision maker is “appreciation potential” — and that too with a minimum requirement for appreciation that increases as interest rate increases (Please note that my calculation of minimum appreciation requirement is only for purchasing your first home because the tax provisions for a second home are different) and the result is dependent on the various assumptions stated in the illustrative example.

. Now that you know what it takes to do at least as well as Shyam (who does not have the burden of debt hanging over him), hope you will make a judicious choice when purchasing your first home.

This is part of a fortnightly series on personal finance. Email your queries to shyamscolumn@gmail.com

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