Recently, I came across a viral content on social media where the author referred to home loans as a scam. Why?
The author took a loan of Rs 48 lacs. EMI of Rs 42K. After paying 15 EMIs, the author had repaid only Rs 75,000 in principal and Rs 4.8 lacs in interest. And it dawned upon the author that her total outgo for the loan will be way more than the actual loan amount.
While I do not have the loan details, I reverse calculated the interest rate based on details shared. A loan of Rs 48 lacs at 8.6% p.a. for 20 years would have an EMI of Rs 42,000. At this EMI, you will have to pay approximately Rs 1 crore to close the loan of Rs 48 lacs over 20 years. Essentially, total interest paid exceeds the original loan amount.
Seems the author has a point, but that is not the right way to think about home loans. In this post, let us see why.
All Loans Work in the Same Manner…All over the World
Do not single out home loans. All loans (all over the world) work in the same manner. Exactly the same manner. All loans will charge interest. All lenders will require you to repay the principal too. There is no other way.
Yes, there may be some tweaks in the mix of interest and principal repayment in the amortization schedule.
For instance, in regular EMI based loans, a portion of your EMI goes towards interest payments and the remaining goes towards principal payment.
In a bullet repayment loan, you just keep paying the interest amount and make a single shot bullet repayment at the end of the loan tenure.
You can think of any number of variations, but, for any loan, you must pay interest on the outstanding principal. And you must repay the principal. That’s how loans work.
Here are a few features of EMI based home loans.
- During the initial years, a greater portion of the EMI goes towards interest payment and only a small portion towards principal repayment. The allocation reverses during the later years. That is a feature to keep loan payments affordable and predictable.
- That is also why the outstanding loan amount falls gradually during the initial years.
- The longer the tenure, the more interest you pay.
For more on how home loans work and to get answers to common queries about home loan workings, refer to this post (How Home Loans work?).
You Take CREDIT for Two Reasons
- You want to buy an asset or must meet an expense, but you do not have the money.
- You have enough money to meet your expenses or to buy the asset, but you think you are better off not spending your own money and taking a loan instead. You may decide against using your own funds due to liquidity constraints, exit penalties, tax implications/benefits or simply because of a higher return expectation than the cost of loan.
Consider any kind of loan: Home Loan, education loan, medical loan, personal loan, car loan. I cannot think of any other reason for taking the loan except the two reasons mentioned above.
And credit cannot come free.
With Loans, Compounding Works in Reverse. And That’s Not Unfair
When you deposit money in a bank account or open a bank account, do you not expect to earn interest on that amount? You do, right? When a bank lends you money, is it unfair for the bank to charge you interest? No, it isn’t. Your loan is an investment for the bank. It must earn return on the capital invested.
You put Rs 20 lacs in bank fixed deposit at 7% p.a. and keep renewing it for next 20 years. Assuming the rates stay constant and ignoring the impact of TDS and taxes, you will get Rs 77.39 lacs. Your original investment of Rs 20 lacs goes 4X over 20 years at a not-so-exciting 7% p.a. return. That is compounding for you. The bank will not hold it against you and call it a scam.
Just like compounding worked in your favour when you made a bank FD (or an investment), the compounding works in bank’s favour when it offers a loan to you. When you take a loan, compounding works in reverse for you. That is plain math. No scam.
Hence, comparing the total amount you pay to close the home loan to the original loan is not appropriate.
If you want to reduce the impact of reverse compounding, you must try to keep making regular prepayments. RBI also prohibits any prepayment penalty on floating rate home loans. Hence, you do not incur any additional cost of repayment.
Choosing Investment over Home Loan
This is the worst kind of argument, at least in my opinion:
Instead of taking Rs 80 lac loan to buy a house to purchase a Rs 1 crore house ten years ago, if you had started a SIP in a small cap mutual fund with the EMI amount, you would have Rs 3.8 crores. You could have bought the same house now (say for Rs 2 crore) and still be left with Rs 1.8 crores.
Well, the last 10 years could have unfolded in a vastly different way. And buying a house on a loan could have turned out to be a vastly superior decision. You cannot judge the quality of the decision based on the outcome.
Everybody is an expert at hindsight investing. And if you regret your house purchase decision so much, you can still sell your house and utilize proceeds to make that investment (you missed out on). Trust me, not many will take up this challenge. Investing is much more than picking the right investment products. Discipline is as important and seems easy when you are looking at the past data.
Rental Yields vs Home Loan Interest Rate
In India, the rental yields on residential real estate are about 2-3% p.a. On the other hand, the home loan interest rate will easily be 8-10% p.a. currently. Hence, the EMI will be much bigger than the monthly rent. Let us consider an example.
To stay in a property with a market value of Rs 1 crore, you must pay rent of about 2.5-3 lacs per annum. That is about 20-25K per month.
On the other hand, if you were to buy this house with 20% down and a loan of Rs 80 lacs at 9% p.a. for 20 years, the EMI will be ~72,000.
Rent of Rs 25,000 vs EMI of Rs 72,000 (+20 lacs for downpayment). Home loan EMI is almost 3X the house rent.
Hence, buying a house will always look like an expensive decision. The EMI outgo will be far bigger than the rent you must pay to stay in a similar property.
Only two scenarios in which this may not hold.
- The difference between rental yields and home loan interest rates goes down sharply (as is the case in developed countries).
- You make a big downpayment. A bigger downpayment means a lower loan amount and a smaller EMI.
Accumulate Funds and Buy a House Later
This is a prudent approach. Reduces the loan amount and thus the EMI. Additionally, if your career is on the right track, your income will also grow with time and the EMI will seem a lesser burden on your cashflows.
However, there are a few things you must keep in mind:
- Owning a house provides emotional comfort and financial security to the family. Memories you will create in your own house. You cannot model these on a spreadsheet. Hence, you must see how long you want to delay this.
- If you do not buy the house, you will continue to stay on rent and will have to pay rent. You must consider rental outgo in your decisions.
- Remember while the EMI is constant, rents tend to go up gradually over the years. Rents can even rise sharply, as many tenants in Bengaluru have experienced over the past couple of years.
- Yes, EMI will go up and down as the interest rates change, but the rentals usually move one way and that is up. Over the years, as the rent increases, the difference between the EMI and the house rent will decrease. Continuing with the above example (EMI of ~72K and rent of 25K) in 10 years, it is possible that the loan EMI is 1.5X of prevailing rent instead of 3X currently. Hence, as the time passes, EMI will look less of a burden.
- The value of the house may increase in the coming years. What if the value of Rs 1 crore house grows to Rs 2 crores over 10-12 years.? There is no guarantee that your investments will grow at a brisker pace than the rate of appreciation in property prices. If your investments underperform property price appreciation, you are back to square one.
I Am NOT Getting into Buy vs. Rent Debate
While this post may give the impression that I am tilting towards “Buy” in “Buy vs Rent” debate, that is not my intention. I do not imply that you must take a home loan and buy a house as soon as possible. Borrowing beyond your means will eventually land you in trouble.
Whether you should buy a house (on loan or otherwise) is not your decision alone. It is a family decision. Additionally, it is not so much a mathematical problem. There are so many aspects that you cannot even model on Microsoft excel. I have written about this in detail in one of my earlier posts. Interest payment to the bank is the same as rent. Rent that you pay to the bank for borrowing funds (instead of paying rent to the landlord).
Yes, “How you should fund the purchase” may be your decision and I trust your judgement.
I don’t want to digress too much in this post. My intention is merely to highlight how home loans work and how such loans help you buy your dream house that you cannot afford outright. Whether you choose to take a home loan or not depends on your preferences and finances. However, do not vilify home loans (or any loans) for the sins they have not committed.