Your first ‘dream home’

Published in The Hindu - Sunday Magazine on Jul 20, 2008

Buying your first home just to save on rent or to get tax benefits does not make financial sense. The key is appreciation potential

The 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 dispassionate 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 only from appreciation

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, check if the 'appreciation potential' meets the minimum criteria when purchasing your first home.

Using credit wisely

Published in The Hindu - Sunday Magazine on Jul 6, 2008

Despite the high risk of debt trap posed by credit cards, I am an optimist who believes that access to credit in a convenient, card-based form is probably the strongest economic catalyst in India, next only to the mobile phone. The wonderful thing is that both have become equaliser of sorts, with access extending from the CEO to the self-employed. On a more serious note, the credit card has helped cure my backache, caused by a bloated purse. Of course, the unintended side effects are on the rise — e.g. I have forgotten how to count “change”, soon I expect to forget how to buy a ticket — what with the co-branded credit card that doubles up as the Delhi Metro pass.

Let me discuss the interest charge on credit cards this week using the habits of two personalities. The first person is my cab driver. He regularly uses his card during the month to pay for his key operating expense, fuel, so that when he receives his payment the following month, he can clear the bills on the card — in effect making his card a source of interest-free working capital loan.

Misconception

The second gentleman, an erudite relative, uses the credit card for occasional purchases (obviously attracted by its convenience and safety) but sends a cheque to the card account after every purchase! When I enquired the reason for his rather strange practice, he claimed that the interest rate on the credit card starts ticking from the day of purchase! Does it? At least, not for the person who pays the full amount on the card bill. In this case, your credit card allows you to spend for a whole month, after which you get your statement and an additional 20 days to settle the bill with zero interest applicable (a free credit). A smart credit card user pays his bill in full but close to the due date, so that he is not charged a penalty, while at the same time he can save the interest cost of an entire month’s expenses. People who invest their capital in a business or otherwise, can easily earn 1-2 per cent return during this 50-day window of delay offered by credit cards.

So, when does the credit card stop offering free credit? Or alternatively, under what condition is the interest charge levied on your credit card from the date of transaction?

a) Cash withdrawal: Most credit cards offer a separate “cash withdrawal limit”, which is a subset of your overall credit limit. This feature is unlike your regular credit card usage and has entirely different set of terms, which make a strong case for staying away from the facility. Firstly, there is service fee, ranging from 3-5 per cent, with a minimum of around Rs. 500 that is charged upfront whenever you withdraw cash on your credit card. Secondly, the interest rate levied on cash withdrawal could be higher than the interest rate on your regular revolving credit. Also, the interest charges will start ticking from the day of the transaction (unfortunately favouring the paranoia of my erudite relative). In addition to these penalties, a further blow comes from the fact that repaying cash withdrawal is not that simple. For example, if you made purchases worth Rs. 10,000 on your credit card plus withdrawn cash of Rs. 5,000 during a particular billing cycle, your cash withdrawal will not be settled unless you pay the entire balance of Rs. 15000. i.e you cannot settle the higher interest cash withdrawal separately. Given the various conditions surrounding cash advance on credit card, it is a much cheaper idea to take out a personal loan, unless you are in a dire emergency.

Pay in full

b) If you don’t pay your balance in full: Assume that your card statement is generated on June 18 with July 8 as the due date for payment and you decided to pay only a portion of the total outstanding. Then the interest charges in your next billing cycle (on July 18) will be calculated on “all unsettled transactions” from the date of transaction occurrence — not only for those spends in the previous billing cycle (going back to May 18) but also for the fresh spends in the new billing cycle (starting from June 18). With this harsh logic and a typical monthly interest rate of 3 per cent charged by card companies, if you keep paying only the minimum due on your credit card (usually 5 per cent of total outstanding or Rs. 200 whichever is higher), it would take 13 years to pay off an outstanding balance of Rs. 50,000 and you would have paid Rs. 71,000 in interest alone!

Whether you want free credit or expensive credit is for you to decide, but the credit card is here to stay.