Every middle-class person faces this question in their lifetime – should you buy a house or rent it instead? Buying vs renting a house can be a dilemma that even seasoned professionals struggle with. There are pros and cons in both situations and in this blog we will try to dissect and both quantitatively and qualitatively and ascertain which option is better for you.
Qualitative Factors in buying vs renting
While we will come to numbers, first let’s discuss some qualitative factors which might very well be more important than numbers.
While conventional wisdom suggests that one should buy a house as soon as one is able – ‘able’ is the keyword and there is a constraint of disposable income. Buying a house is a big commitment and one should have a stable income source and that too with a high monthly income to support EMIs after providing for monthly expenses and saving for emergencies.
City of Choice
Jobs take people to various cities. Do you want to settle down in that city or are you just living there because the job requires you to stay there? Are you willing to move if a better job requires you to move to another city? These are some of the questions that one must answer before committing to a house.
Area Preference vis-a-vis ability to pay
For the same house, generally rent would be less than half of EMIs. Now if you are working in a prime area and buying a house nearby is not an option & you prefer shorter commutes, renting might be the better option. On the other hand, if the job is in a relatively cheaper area or if commuting is not an issue, may-be buying is the way to go.
Sense of Ownership
This relates to the sense of satisfaction or safety that a person associates with buying a house. Weirdly enough, when home-loan and home-ownership are weighed, for different people the scales tip in different directions. Some people would rather have a loan-free existence and others might want an ‘owned (loaned)’ house.
How good are you are managing finances
This is important for 2 aspects:
First, if you are not very disciplined and you don’t keep breathing room, there might be problems with loan repayment which can be very bad for you.
On the other hand, if you think that disposable income leads you to do spends (which otherwise you could have avoided) then buying a house and paying the loan will act as force saving mechanism.
Many people would associate a higher degree of worth to the first house than they would do to a second or third house. This is again because of a sense of security that if something happens, at least they have a place to call their own. So if the question comes to the first house, then often buying vs renting decision is made on emotion.
You can find this article here
Quantitative Factors in buying vs renting
If the qualitative factors support the decision to buy the house, then let’s come to the quantitative factors. Obviously, if the qualitative forces are very strong and the decision is being primarily driven by emotions and not by numbers, then these quantitative factors might not be able to change much. However, even then, do go through them, there will still be useful tips which can be used by you.
Taking the amount in lacs and after considering the tax benefits on interest repayment on the house loan and also the HRA benefits in rent payments, the numbers work out as below.
So basically, the 75L house becomes ~ 164L after 20 years taking ~4% appreciation. While if we stay in a rented apartment and the savings get after-tax returns of ~8% we will get a corpus of ~147L after 20 years.
These numbers tell that house value is more than the investment, so one might think that buying is a better choice. However, please do understand that these models are only as much accurate as per the assumptions that go into the model. Now, these assumptions will change for different people, places, and circumstances.
Lets discuss these assumptions
Income tax rate
The marginal income tax rate taken in the example is 30%. If the individual in question is subject to another tax slab, the analysis would have to be modified accordingly. There are tax benefits in both the options – in buying the interest portion of payment has relief up to 2L whereas in renting HRA benefit is there. Again, if the individual does not do a job then HRA benefit might not be applicable so that adjustment will have to be made.
Rent & rate of Increase
Here annual rent is taken as 4% of property value. There are cities where rent % is lower – like Mumbai which might favor renting; other places like Bangalore might have rent as 5% which might favor buying.
Also, the rent increase is taken as 5%, however, there might be situations where rent is controlled and does not increase at that rate. On the other hand, there can be situations where rent can increase at a higher percentage (10%?). These all have to be taken into account as per individual situations.
Home Loan Rate
Home Loan Rates can be different for different people basis the credit history or age/gender etc. There can be some schemes from banks or government for a certain section of society that might make either option more lucrative.
Read about ‘Pradhan Mantri Awas Yojana‘
Rate of Return on Investment:
I believe that this is the most important factor which is often misunderstood or incorrectly calculated by individuals. This should not be a fantasy number. This should be the after-tax return expected by the individual in question.
If you put the money in fixed deposits that that is the return you should take, not for equities. Secondly, there is a reason to adjust for risk here. Taking very risky bets to justify not buying a house might not be very accurate and land one in trouble.
I did a sensitivity analysis on this and found that if the rate of return varies from 4% to 12% (assumed 8% in the model) the invested value of savings will vary from 82L to 269L. Hence it can be either way below the future value of the house or way above.
Therefore, this is a make or break metric in the calculation, and the reason why different people will give you different recommendations on this – basis what they take as input. The idea is that this metric should be decided by YOU
Do Read: Factors that influence investment
Home appreciation rate
This is yet another important metric. If your decision is driven by numbers and you expect to turn a profit by buying a house, you should try to buy in an area and at a time when higher appreciation is expected. Buying when/ where the prices are already very high might also lead to negative returns, which might be very problematic
Again, this metric is critical and should be taken basis time and place, otherwise modeling exercise would be: GIGO (Garbage in, Garbage out)
Final verdict in buying vs renting
House purchase is often one of the most critical financial decisions that a middle-class person makes. This is because most middle-class families buy only 1 house in their lifetime, even if that. Hence the confusion of buying vs renting generally rages on till that 1st house is bought.
As explained above, there are many factors which can influence the outcome in favor of either of the option. However, because buying is a long term commitment, my recommendation is to rent until you are reasonably sure that you want stability and want to develop roots in that place. Post that once you have already decided, you run the numbers to justify your decision. 😉
Do let me know how you arrived at your decision and if you think your decision was solely based on numbers.