Is it better to rent a house or buy one?

Have you put off buying a home because of high prices or rising interest rates? As home loan interest rates rise — and with them, the equated monthly instalments — many of us are faced with the dilemma of whether we should continue in rented premises or take the plunge and buy a new home.

While we have analysed the issue based on the numbers, the decision isn't easy and cannot, in fact, be based purely on numerical factors. We take you through the pros and cons of the rent-versus-buy decision.

What to consider while renting

Renting a home is the best bet for those of us who seek affordability and flexibility and can invest our savings quite actively.

It is also the best option for individuals who would like to stay within city limits and avoid a long commute to work. Given that rental yields in India tend to be quite low (that is, rents amount only to 3-3.5 per cent of the home value at the most), you can rent out a three-bedroom apartment for much less than it costs to own it. This means substantial monthly savings, which, if you invest wisely can lead to a big corpus.

Renting also allows you to ‘upgrade' to a better home, if your economic conditions improve.

Owning an asset, especially a big one such as property, brings with it several costs and risks. Maintenance and replacement costs may mount as your house grows older. You will also not have to monitor and bear the risks of swings in real estate prices or interest rates. However, if property prices correct, generally, house-owners never reduce the rent for a tenant.

However, renting can have its pitfalls too, and not just from a finicky landlord.

Take note of these factors:

If you are worried about the EMIs on your home-loan rising with interest rates, staying in rented property may be no easier on your purse. Staying in a rented flat is no protection from inflation because rents, in fact, tend to rise at rates that match, or even exceed, inflation rates.

Rents on residential property are likely to trend up quite steadily over the years, for two reasons. One, with demand for rented homes remaining quite strong, especially within city limits, and supply not keeping up, home-owners tend to peg up rents in step with, or even disproportionately to, property prices.

Two, given that rental yields in India are currently quite low (3 per cent or less in most localities), there is scope for yields to rise too. Which means that rents may rise more quickly than property prices.

Given that demand for accommodation is always quite stiff in the cities, if property prices increase, most home-owners are tempted to look for new tenants and raise the rentals. Therefore, there will always be a threat from the home-owner for a tenant to vacate his property.

THINGS TO NOTE WHEN buying

Buying a home is one of the biggest financial investments you may make in your lifetime; and that's not just because of the sentimental value. The sum that most of us sink into our home does make it the largest component of our investment portfolio!

The pluses first:

For any of us who have seen property prices boom over the last five years, the prospect of mouth-watering capital appreciation is the biggest argument for buying a home. Construction costs alone, which account for more than 70 per cent of the flat's cost, have risen at 15 per cent annually in the past decade. Rents too seem to keep up with inflation, making a home one of the few investments can shield you from inflation for the long term.

Low interest rates. Though interest rates may be rising now, do remember that buying a home is a long-term decision. Over a 15-year period, the interest rates may go through several up-and-down cycles. Therefore, you can be sure that you will benefit from falling rates at some point in the cycle. There could also be situations in which the interest rates fall, allowing you to prepay your loan and own your home. For instance, those who bought property in 1995, at an interest rate of 18 per cent, not only saw interest rates fall dramatically over the next decade, to bottom out at about 7.5 per cent, property prices too appreciated steeply. A double boost to wealth.

The preferred status given to home loans by banks tends to make for very attractive interest rates on such loans. The tax benefits that allow you to claim a deduction from income on the interest portion of your home loan (the principal portion may not be eligible once the new Tax Code comes into the picture), also lowers the effective cost of the loan.

The minuses of buying property arise mainly from three factors. First, if one has bought the property with a rather high leverage, increases in interest rates can threaten your disposable income. And, second, the government can be quite fickle in its tax laws. If you have factored tax benefits into your calculations while taking your home loan, any withdrawal of this may throw your calculations into disarray. Third, if property prices correct or even grow at a slower pace after the purchase, there is potential for loss in the capital.

Some of the above arguments are qualitative, but many can be reduced into numbers. If you take a hypothetical case and see whether renting or buying works out best for an investor, what's the answer?

Well, it seems to hinge entirely on the rate at which property prices appreciate.

A case study

Let's compare two individuals. One, Ram, is willing to buy a flat at current prices, while the other — Shyam — prefers to stay in a rented house. We assume Ram funds the flat cost of Rs 33 lakh with his own capital of Rs 8 lakh and the balance through a loan of Rs 25 lakh for 15 years at an interest rate of 10 per cent. His monthly commitment (equated monthly instalment) towards the loan will be Rs 26,835.

Assuming that the interest rate remains the same throughout the 15 years, he will pay back a sum of Rs 48.35 lakh to the bank. Assuming he is in the 30 per cent tax bracket and earns tax benefits on the interest component alone (in deference to the new Direct Taxes Code), he would shell out a net sum of Rs 42.75 lakh.

Now, assuming property prices increase at a rate of 7 per cent, his Rs 33-lakh home will be worth Rs 91 lakh after 15 years. His investment in the property fetched him an appreciation of Rs 40.25 lakh. That is an internal rate of return of 6.9 per cent.

Now, coming to Shyam. He decides to rent a home very similar to that bought by Ram. Assuming rental yields of about 3.5 per cent, he would need to shell out about Rs 10,000 per month in the form of rent. Now, as property prices are rising by 7 per cent every year, the landlord will raise his rent too by a similar amount. Having not invested in a home, he has a surplus every month (the notional value of the EMI minus the rent paid) to invest in safe instruments.

Let us presume that Shyam is able to avail tax benefits at 30 per cent of the rent paid, by way of HRA. In the first year he saves monthly a sum of Rs 19,835 (Rs 26835 - Rs 7,000) and invests Rs 7 lakh ( margin money for buying a house) at a post-tax return of 7 per cent. At the end of 15 years his total savings will be worth Rs 68 lakh. He would have paid out Rs 21 lakh by way of rent. His IRR would work out to 2.5 per cent. Though the investor saves quite a bit in initial years, the rise in rents reduces his savings in later years.

In the above instance, obviously, Ram has got a much better deal than Shyam.

Therefore, buying a home will pay off most for people who plan to stay in one location for a long horizon (say 15 years) and those who are in the higher tax brackets. Apart from this, property prices have to appreciate at a reasonable rate, preferably higher than inflation.

Managing the interest rate

With interest rates rising steadily, people wanting to take a loan are worried they may get locked into higher interest rates while new borrowers get better deals. However, with floating rates becoming the norm for home loans, investors cannot avoid one or two interest rate up-cycles over the 15- or 20-year tenure of their home loan.

Thus, the best way to manage borrowing costs is by actively managing your home loans!

That's not as difficult as it is sounds. Banks and home-loan lenders often give new borrowers much better rates than existing borrowers.

During the uptick of the interest rate cycle, if your cost of borrowing increases by more than 2 percentage points, pay 0.5 per cent of the loan outstanding as processing fee (conversion charge) to your lender to avail the rates offered to the new borrowers.

Even if you use such swap facilities four times during your loan period, your cost of borrowing will not go up by more than 2 per cent of the loan amount.

To give a live example, in the year 2000, home-loan interest rates hovered at 12.75 per cent (EMI Rs 1,249 per lakh). They gradually fell to a very low 7.5 per cent (Rs 927 per lakh) in 2003, and stayed there for two years before they rose again.

Those who took home loans between 2003 and 2005 and used interest rate swaps actively would have been able to retain their overall borrowing costs at around 10 per cent (Rs 1,075 per lakh).

A passive borrower would, in contrast, still be shelling out 13-14 per cent.

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