“Home is an invention on which no one has yet improved” -- Ann Douglas
What is the best way to build financial security and boost long term investment success?
Traditionally, the most common approach to prudent financial planning focused on buying a home. However, what was once accepted as financial gospel is now considered debatable. With changing attitudes and lifestyle goals, the millennials stand divided on the wisdom to buy a first home and are neutral about renting while prioritizing personal consumption and investment in financial instruments.
Given the importance and financial weight of a real estate decision, we think it’s important to carefully evaluate the merits of buying a home and how it can sway an individual or a family’s long-term well-being.
To begin with let us be clear that buying a first home is not the same as buying your dream home or a shortcut to riches but to assess if it can lay the foundation to eventually do so.
UTILITY - SECURITY PERSPECTIVE
Owning a home has value since it allows complete freedom to express oneself. Pride of ownership is a major reason why people yearn to own their homes. It means you may decorate the house according to your taste, attach permanent fixtures or socialize freely with a close-knit community. Besides, owning a home is invaluable for most people for the emotional connect and the family memories it creates.
Most importantly owning a home provides a sense of stability and security. The comfort of home ownership allows a family to tide over difficult periods like recessions without a major disturbance in lifestyle. Once this stability is assured, one can also look to then freely invest in riskier instruments like stocks and mutual funds. Moreover, a home in itself is a valuable asset which appreciates overtime thus adding to overall wealth and social status.
The biggest challenge to owning a home for most people is the significant financial commitment it involves. While having reservations is natural, a careful analysis of the long-term financial benefits can allow you to make a confident and informed decision.
(i) Enforces Saving Discipline: the key element of judicious long-term financial planning is disciplined savings. It is advisable is to approach expenditure as a residual of income minus savings and not vice versa. Since most home-buyers purchase a home through a mortgage, a prudent saving practice is automatically built into their budgets because of the need to pay periodic EMIs.
The importance of this cannot be overemphasized since all the cut down on wasteful expenditure is getting channelized into financing a capital asset (home) which not only provides security but also builds long term wealth.
(ii) Inflation Hedge: another benefit of buying a home from financial planning perspective is that it helps eliminate sunk costs of paying rents. Historical evidence suggests that in the long term, average rentals tend to increase at the rate of inflation. Thus, home ownership acts as a perfect hedge against inflation since the mortgage EMIs remain more or less constant while rents escalate at roughly 4-6% annually (avg. inflation in India).
(iii) Rental Yield vs Interest: a common argument presented against buying a home in India is that ownership is expensive as compared to renting since the average rental yield is 2%-4% while interest on home loans is 8.0%-9.0%. We think this is an incomplete assertion since it does not account for the total long-term rental v/s interest cost. Moreover, staying on rent is akin to consumption expenditure which is a sunk cost while paying EMIs on a home loan is an investment in building an asset which grows in value overtime. Let us examine this with an illustration for an apartment costing Rs 1 Cr.
Rent: assuming an average rental yield of 3.0%, the current monthly and annual rent would be Rs 25,000 and Rs 3,00,000 respectively. Assuming the rentals escalate annually at the expected inflation rate of 5%, the total rent paid over 20 years shall be Rs 99,19,786. Extending this to 30 years, the total rent paid shall be Rs 1,99,31,654.
Home Purchase: a home-buyer can typically finance a home with a loan to value ratio of 80%. Assuming a 20-year loan at an average interest rate of 8.5%, the total interest paid over a 20-year period shall be Rs 86,62,206. Interestingly, since the loan gets paid off in 20 years, the total interest paid even over a 30-year period shall remain constant at Rs 86,62,206.
We can note from the above analysis that over longer periods of time, renting gets increasingly costlier as compared to buying a home. At the end of 30 years a renter would have paid an accumulated sunk cost of Rs 1.99 Crores and would own nothing at the end. In contrast a home-buyer would pay an aggregate interest of Rs 86.6 lakhs and end up owning an asset which would be worth significantly more than the original purchase price.
A prominent advantage to buying a home is that unlike renting, buying a home is an investment in real estate which contributes to building long term wealth. There are some inherent features of property investing which are naturally aligned to produce favourable long term results.
(i) Leverage Enhances Returns: most first-time home-buyers finance their purchase through a home loan. Thus, any returns on their property are enhanced by the multiple of total cost is to self-contribution. Moreover, because of the relative stability of underlying assets, it is typically possible to obtain a relatively high loan to value ratio for residential real estate of close to 80%. This is unlike financial instruments like stocks where it is generally not possible to leverage your investments more than 50% on margin.
More importantly, the leverage in real estate is structured as a loan which is repaid through pre-set monthly installments, thus eliminating the worry (risk) of an unfavourable liquidation on account of an untimely margin call.
(ii) Tax Benefits: there are multiple tax benefits of owning a property. A home-buyer can avail of an annual deduction of up to Rs 2,00,000 on interest paid on home loans (Section 24) thus reducing the effective interest rate. Additionally, a deduction on repayment of principal is allowed under section 80C for up to Rs 1,50,000. In case of joint loans, these deductions are allowed for the full amount to both the borrowers!
Long Term Capital Gains Tax: the long-term capital gains on residential property are taxed at 20% with indexation. However, section 54 offers a particularly favourable provision, which allows full tax exemption on long term capital gains if the proceeds are used to purchase another residential property.
(iii) Simpler to Understand-Tangible Asset-Long Term Holding: since real estate is a tangible asset, it allows for greater control in the hands of its owners. Also, being a physical asset with straight forward revenue and costs, makes it relatively easy to understand even for unsophisticated investors. Thus, home-buyers do not have to depend on management team of stocks they own, portfolio managers or third-party analysts for managing their investments. For those willing to put in the work, they can control their investment and make informed decisions by at best engaging a prudent real estate advisor.
Another inherent advantage of property investment is that though cyclical in nature, real estate is not volatile like stocks which are constantly traded on an exchange. Moreover, it is not constantly in the media, so a home-buyer does not have to bother about being cluttered or swayed by the ever changing asset prices or incomplete views of TV experts.
It is thus not surprising that we frequently come across average people who made their wealth through real estate. This is because the intrinsic characteristics of real estate investments- simplicity, low volatility and a relatively longer period allows for effective compounding and hence enhanced returns.
Noting the innumerable benefits of buying a home, it’s not surprising that the greatest and wisest investors like Warren Buffet and Peter Lynch prioritized home ownership and recommend the same to others. A first home may not always provide the highest absolute returns, but it sure is a smart way to build financial security and a bedrock for more elaborate investment planning.