# Pay Rent to the Owner OR Rent to the Bank

Should you stay on rent or buy a house on loan? Many of us think of house rent as a waste of money. A common refrain is, “You are already paying so much rent. Why not adding some money and pay the EMI? After a few years, you will also own this house.”

In my opinion, purely from mathematical perspective, this is not a correct statement. You pay rent even when you borrow money from the bank.  The only difference is, when you rent a house, you pay the rent to the house owner. When you take out a home loan, you pay rent on the money that you have borrowed from the bank.

## How Is That Possible?

When you pay an EMI, then the entire amount does not go towards the repayment of the loan. First, the interest for the month is recovered from the EMI. Thereafter, the remaining amount is used to reduce the principal amount. I have discussed the calculations behind EMI is detail in this post.

For the sake of completeness, I will include an example here. Let’s say you take a loan of Rs 50 lacs at 10% p.a. for 20 years. The EMI will be Rs 48,251. When you pay the first month EMI, Rs 41,667 will go towards interest payment and the remaining Rs 6,584 will go towards principal repayment.

## What Does This Mean?

You must pay Rs 50 lacs to the bank to completely own the house. However, when you pay the first month’s EMI, the outstanding loan goes down by only Rs 6,584. Despite paying Rs 48,251 in the first month, your loan outstanding stands at Rs 49.93 lacs. The interest paid is essentially the rent that you have paid on borrowings from the bank. In fact, over the course of 20 years, if the interest rate were to remain constant and you didn’t make any prepayments, you will pay 240 X 48,251 = Rs 1.16 crores to the bank. The loan amount was only Rs 50 lacs. Any excess (Rs 65.8 lacs) goes towards interest payment, or in other words, rent on money borrowed from the bank.

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#### Monthly rent payments start off low (due to current low rental yields) and keeps increasing by ~5-10% each year

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Let’s assume the choice is between paying rent of Rs 40,000 or buying a house on home loan.

How much loan? The rental yields in residential real estate are about 2-3% p.a. I assume a rental yield of 2.5% p.a. Therefore, for you to buy a similar property, you will have to shell out Rs 40,000 X 12 ÷ 2.5% = Rs 1.92 crores. Let’s ignore stamp duty and other ancillary charges for possession or even the maintenance charges that you will pay subsequently. I am ignoring the tax benefits on HRA and home loan repayment too. I am also ignoring the large upfront security deposit paid for rental properties.

Assume you will pay 25% from own pocket and will take a loan for the remaining amount. So, you will make a down-payment of Rs 48 lacs and take a home loan of Rs 1.44 crores. I am considering a completed or a ready-to-move-in property. Buying an under-construction property will make this analysis even more complicated.

A home loan of Rs 1.44 crores. Loan Tenure of 20 years. Rate of Interest = 8.5% p.a. The EMI will be Rs 1.25 lacs. Let’s further assume that the interest rate won’t change during the loan tenure and you won’t make any partial prepayment.

Rentals won’t remain constant. I have assumed an increase of 5% on an annual basis.

 Year Annual House Rent (A) Outstanding Loan Amount at the beginning of the year EMI paid on an annual basis Principal Repaid Interest Paid or Rent Paid to the Bank (B) Difference between the two rents (B – A) 1 4,80,000 1,44,00,000 14,99,599 2,86,593 12,13,006 7,33,006 2 5,04,000 1,41,13,407 14,99,599 3,11,925 11,87,673 6,83,673 3 5,29,200 1,38,01,482 14,99,599 3,39,497 11,60,102 6,30,902 4 5,55,660 1,34,61,985 14,99,599 3,69,505 11,30,094 5,74,434 5 5,83,443 1,30,92,480 14,99,599 4,02,166 10,97,433 5,13,990 6 6,12,615 1,26,90,314 14,99,599 4,37,714 10,61,885 4,49,270 7 6,43,246 1,22,52,601 14,99,599 4,76,404 10,23,195 3,79,949 8 6,75,408 1,17,76,197 14,99,599 5,18,513 9,81,085 3,05,677 9 7,09,179 1,12,57,684 14,99,599 5,64,345 9,35,253 2,26,075 10 7,44,638 1,06,93,339 14,99,599 6,14,228 8,85,370 1,40,733 11 7,81,869 1,00,79,110 14,99,599 6,68,520 8,31,078 49,209 12 8,20,963 94,10,590 14,99,599 7,27,611 7,71,987 -48,976 13 8,62,011 86,82,979 14,99,599 7,91,926 7,07,673 -1,54,338 14 9,05,112 78,91,053 14,99,599 8,61,925 6,37,674 -2,67,438 15 9,50,367 70,29,128 14,99,599 9,38,111 5,61,488 -3,88,880 16 9,97,886 60,91,017 14,99,599 10,21,032 4,78,567 -5,19,318 17 10,47,780 50,69,986 14,99,599 11,11,281 3,88,317 -6,59,463 18 11,00,169 39,58,704 14,99,599 12,09,509 2,90,090 -8,10,079 19 11,55,177 27,49,196 14,99,599 13,16,418 1,83,180 -9,71,997 20 12,12,936 14,32,778 14,99,599 14,32,778 66,821 -11,46,115 Total 1,58,71,658 1,44,00,000 1,55,91,971 -2,79,687

As you can see, over the next 20 years, the rent that you pay to the owner is almost equal to the rent (or the interest) that you pay to the bank. We can ignore the minor differences. Therefore, a purely rational (unemotional) answer would be that it does not make a difference whether you buy the house on rent the house. You must pay the rent in both the cases.

## Are We Missing the Point?

In the second case, when you take a home loan and buy the house, you own the house at the end of the loan tenure. When you keep renting the house, you don’t own the house. However, you must look at the savings from not buying the house. For the EMI paid over 20 years, you didn’t just pay interest of 1.56 crores. You repaid principal of Rs 1.44 crores too. If you stayed on rent and simply kept money in your bank account, you would have Rs 1.44 crores in your account. Add to that, Rs 48 lacs of down-payment you saved. A clean total of Rs 1.92 crores. That is good enough to buy the house after 20 years. You could have very well stayed on rent for the next 20 years. After 20 years, you could have gone ahead and bought the house from savings (EMI minus House Rent).

## What about Capital Appreciation of the Residential Property?

A fair question. After all, the property wouldn’t be available at the same price after 20 years. It would have appreciated. All you have is Rs 1.92 crores, which wouldn’t be enough to buy the same property after 20 years. Again, we are missing an important point. The down-payment of Rs 48 lacs would have grown over 20 years, if invested properly. Additionally, there are savings on a monthly basis. EMI is higher than the monthly rent for all the 20 years. These savings could have been invested too. Assuming the down-payment and savings (EMI minus House Rent) could be invested at 6% p.a., you would have Rs 4.47 crores at the end of 20 years. The property currently valued at Rs 1.92 crores would have to grow at 4.32% p.a. to exceed this target.  If the money could be invested at 8% p.a., you would have Rs 6.01 crores at the end of 20 years. This would be enough to meet capital appreciation of up to 5.88% p.a. in the property value.

## What Does This Finally Mean?

I am not saying that you should buy the house on home loan right away. I am also not saying that you should stay on rent. The intent is to highlight that the belief that ‘house rent is a waste of money’ is not right. As we have seen, the rent must be paid in both cases, only the recipient is different. Rental amounts were not much different in the example we considered. Of course, that could change with increase/decrease in rental yields, loan interest rates or additional costs in renting/owning a property.

Rent vs Buy is not purely a financial decision though. For many, ownership of house is a status symbol. To some, it provides a sense of financial security and provides emotional comfort. People want to own a place they can call their own. Some want to see their kids grow in their own house. Memories. The above financial analysis doesn’t attach value to these things/experiences. At the same time, renting a house provides you with flexibility of movement and use of savings. Hence, the answer is not very crisp.

As mentioned above, the intent is to help assign the correct value to the costs (rent and the interest paid) that can be quantified and disprove a common belief.

I have always maintained you must plan to purchase a house, before you retire, at a place/city where you would want to stay after retirement. Even if you are staying on rent, plan your investments in such a manner that you can purchase a house before retirement. If you have an ancestral property and plan to live there after retirement, then you can do without this planning too. Now, my opinion/argument may not hold much water financially. However, in my opinion, changing houses frequently can be a serious pain at an older age. And I attach a lot of value to this.

## What Would You Do?

Given the low rental yields in India, I do not find much merit in residential real estate as an investment. The entire bet is on the capital appreciation. Since the real estate market is heterogeneous, capital appreciation depends on your luck and investment acumen. There will be micro-pockets that will do well and there will be micro-pockets that will struggle.

Editor’s Note: Rental yields in India are currently in the ‘Very Poor’ range when compared to global rental yields. If this were to move to even ‘Moderate’ levels — due to increase in demand for rental housing or Model Tenancy Act — then it would make more financial sense to own a home rather than rent one.