Housing Finances…
I know this may sound sacrilegious, but the housing loan (mortgage) interest deduction is the most over-rated tax strategy in existence.
I constantly hear happy “homeowners“ boasting about how much money they “saved“ with their mortgage interest deduction.
Asking your boss to reduce your salary would perhaps have the same effect.
If you are in the 30% tax bracket each Rupee you pay interest on is only going to save you 30 paise. That means you are still spending 70 paise to save 30 paise.
My family believes that I choose to become a CA over IIT because I am weak in mathematics.
Even to my dumb head, this sounds like bad mathematics, correct?
This is actually the classic difference between a deduction and an expense write-off.
Can you convince a businessman that an expense is good, just because it can be claimed as deduction? I doubt it.
The other question that I ask in all my classes “Is a car an asset?“ Thanks to `Rich Dad Poor Dad`; many people having read that, say no.
Then I ask them “Is a house an asset?“ In spite of reading “Rich Dad Poor Dad“, people are still confused. And you`re so happy with this so-called tax break you aren`t thinking clearly about what is really happening.
In the first few years of a mortgage the majority of your payment goes toward paying your interest on the loan, not the principal. And homeowners think that`s fine; it means a bigger tax deduction. But if you can bring some logic to this you would realize you`re not building up any equity because of your payments.
You may be building up equity yes, but that is because real estate prices are going up. The question has to be asked, what happens if they ever start to go down. But let`s just look at why the mortgage companies really have you pay the majority of the interest up front.
First, the stats show that homeowners tend to buy a second house in six or seven years. So that means when you go to sell you`ve only paid interest on your mortgage; you haven`t really paid down any of your principal which means that the lender has been getting interest on almost all of the money they originally lent you which in the long run helps them make more money but at your expense.
At this stage the nice middle class homeowner go back to the lender, pay off the loan and take a fresh loan, and the interest payment cycle continues.
Thank God for my shareholding in India`s biggest mortgage company!
They surely got their maths correct, and so did I!
Let me come to my favorite topic of compound interest. Why do people feel happy about real estate? I think it is simple mental heuristics.
People do not understand the importance of the compounding formula (Future value = present value * (1+ r) ^ n). That is why they come up with “My father bought a house in Santa Cruz (an up market suburb of Mumbai) for Rs 30,000, now it is worth Rs 30,00,000.
We see it as a great 100 bagger! Great.“ However if you see that the purchase was made in the year 1964 and do an IRR it comes to “only“ 11% p.a.
If you factor in the interest cost, maintenance, and society charges, it does not sound too great, does it? This was over a period when inflation was hovering between 9 and 19% in India, and when for many years cost of funds was in excess of 12%.
Also this person was earning a princely sum of Rs 900 in 1964 – which meant he was paying 33 times his monthly salary for a house. However at a CTC of Rs 18L p.a. I am paying only 20 month`s salary. Thus the house, expressed in terms of inflation adjusted return may not be worth it.
Now while I know most people need a mortgage in order to purchase a home, there will come a time in your life when it will make sense to get rid of your mortgage. So I don`t want you to just keep paying a mortgage under the guise that it is your only tax write-off.
Very few seriously rich people have a mortgage. They simply write a cheque. Its simple guys, “its better to receive interest rather than pay interest“. Did you know that only since the Second World War the mass psychology changed from “use value“ to “ownership value“. Earlier, people like my Grand dad (decision circa 1919) was happy to rent 2 houses in Central Mumbai location and pay a rent for the rest of his life.
One more thing I cannot understand is how come we treat different assets differently?
Do you think you and your husband will do a 2nd job to support a Porshce, or a Mercedes? Sounds irrational, correct?
Do you say “Invested in a car?“ Well, I have not heard that ever.
How come you cannot invest in steel but can invest in steel and cement? It beats me, but thankfully the home loan interest deduction is gone after all!! (direct tax code!) –
Manish
Nice post…i emailed this article to all my friends who still thinks that they save money by saving taxes on mortgage interset deductions.
SAM
Subra,
You are definitely not weak in anything… maths or english! 🙂
You can tell your family members… kids who get into IITs these days… especially from Hyderabad… are so overcoached that they are mentally exhausted /shutdown by the time they get into one! Check with the profs!
All said and done… I am a fan of real estate! Worked well for me coz of very different reasons!
Mohana Ganesh
Subra, I think you have lot of followers. Hence, you find a sharp dip in sales of houses in Mumbai. Be careful of builders.
Sanjay Singhaniya
Any idea when DTC will be implemented? I guess not till April 2015. By that time, draft of DTC will be changed to include this interest deduction.
Also, you can invest surplus to a debt fund instead of prepaying a home loan. It certainly gives at least 1% of advantage. thats why interest of home loan is not treated as expense as you employ the same money in debt fund.
Imagine a person getting 8.76% in tax free bonds and paying only 7% effective interest rate on home loan.
Home loan is sought for two reasons : interest rate is low among all type of loans. Second is interest deduction on home loan.
PrAvEen
Sir, What about the rent saved? Isn’t we can deduct “rent saved” from the “interest paid on loan” (one u pay to landlord & other to finance company, both won’t come back)
Even if we take 3% as the rental yield of property isn’t that make 11% – 3% = 8% is what u pay to finance company., & ur EMI will stay as it is but your rental will increase every year.
Steven
Now that I have been following your blog everyday for the past 4 years. I recognize that this is an old post of yours 🙂
Thanks a lot for all the knowledge that you have shared and enlightened me.
A big thank you
Steven
LuckyOye
Subra,
I will take a contrarian view to this post. It has several conceptual as well as factual errors.
“Is a car an asset?” It is not an asset today simply because cars today are engineered with a limited usable lifespan of maybe 10 years, with huge maintenance costs towards the end. I guarantee you, if cars were engineered for a usable life of 50 years, with minimal/zero maintenance costs, it would be considered an asset. Just do a mental exercise of this situation.
“Home lenders WANT you to pay high interest/low principal for initial few years” Factual error. The reason interest is high initially is simply because you have a larger principal outstanding. CAN you repay back entire Principal immediately after you get the loan? If you could why would you take the loan in the first place? Do you WANT to pay interest on interest to the lenders? No, so pay entire interest on outstanding and repay a little principal. Hence the concept of EMI. Hence they let you choose your term and the EMI amount gets decided based on that. If you have a better payment mechanism in mind which doesn’t trouble the borrower, kindly outline it in your post(s).
“Very few seriously rich people have a mortgage” Come on, rich people by definition have the money, why will they take a loan for personal stuff? But rich people have TONS of money borrowed by the companies they own. Ask Birla or Mallya how much THEIR COMPANIES owe your favourite bank!
I could go on and on…but you get the idea..
Only good point is this:
House loan gives poor tax benefit…for certain. Even today, you can get better tax benefits out of renting and claiming HRA deduction (no 1.5L pa limit)
Mira
My friend bought a 2 BHK flat in 2004 @ 25 lacs. It has gone for redevelopment and would get 3 BHK flat. Its current value is 2.75 Cr. How would you explain this appreciation.
Manish
Mira,
Please provide following details
Did ur friend brought flat on loan? if yes, How much is interest paid til now or rate of interest ?
How much ur friend paid in maintenance cost of society (monthly/yearly) and on property tax ?
How much money ur friend need to pay for redevelopment from 2 BHK to 3 BHK ?
Please take into count inflation for calculating returns . I mean inflation for last 10 years
Did ur friend brought flat for investment or he/she is living in it ?
Does ur friend has any liquid investment or contigency fund to take care of emergency some crtical illness or is he/she depends on sale of property to take care of any emergency . I know many people whose 80-90% of portfolio is in real estate and they believe in emergency they can easily get some buyers for the flat in 1-2 weeks ?
subra
Mira,
my friend bought Wipro in 1980 for Rs. 1000 and sold for Rs. 30 crores after almost 27 years.
Please tell me what can YOU do with that information.
Manish
25lakh invested in mortgage company in 2004 is now 29 crores Can u please explain this .. So i would say ur friend lost an opportunity to earn 26 crores more. Poor guy 🙂
Jitu
I guess the point Subra wanted to make : we stretch ourselves way too much in the name of “Investment in Property”
I have seen one of my best pal, paying EMI of 40k from his sal of 70k, for his newly purchase home. His justification, “Zindagi main ek risk to lena he padta hai, to le liya”
He has a daughter who’ll start going to school in year and half, old parents to take care of….and ya did I mention he had luxury to borrow some money from relatives (without interest, which he repaid) for the downpayment….
Situation is scary, when you borrow, way…way beyond your means…and that’s what Subra is trying to put up front, (please correct me Subra, if am wrong)
param
i bought a house for 26 lac & people say it is worth 60 lac now (neither am i looking to sell, nor has anyone made me an offer). however, even after i sell, the similar property would need to be bought at 70 lac. in effect, increase in value of currently used property is meaningless unless you can sell without impacting your lifestyle…
Mira D
Very good point re Wipro, Subrabhai…makes me feel better.
Manish– The builder will take care of maintenance of the new apartment for 5 years.. and no money has to be paid for redevelopment.The older apartment was bought with minimal loan since they had the FIl’s retirement funds…
They have adequate contingency/ emergency funds since it is a 2 income family run with prudent expenses.
Manish
Mira,
will say ur friend is lucky he has money to buy 25 lakh flat without taking loan and even the redevelopment happened without paying any money..Lucky guy 🙂 🙂 🙂 believe 80%(guess) of indians will be buying property on mortgage. so do u thkink is it worth right now to take mortgage for property…
Mira D
Well, this saturday I prepaid every paise of my home loan…
As they say, “Your mileage might vary”. Doesn’t make financial sense, but there may be family commitments/ sentimental reasons.
PrAvEen
seems there’s a gap 🙂
The buyer side arguments is of their first/living home which saves expenses like rent & inflation proof, & the other side argument is comparing it’s from an investment perspective or a second home bought to rent out/or in anticipation of raising prices
PrAvEen
@Jitu
If we live in a city like bnglr & we see the appreciation in rent is a way more then the appreciation in your salary (if you work for same company) then after 5 years we are feeling that if I bought the same house on FINANCE 5 years back, now both my EMI & rent will be same (hindsight???).
Ppl may say this rental appreciation won’t sustain long but that I can say only after 5 years 🙂
vIvEk
@Praveen
This rental appreciation does not applicable to all the areas in Bangalore it is mainly in IT dominated areas like Koramangala, BTM, Marathhalli, HSR etc. but it does not rise same way in other areas say as in Vijayaganar, Rajajinagar even though they are much much older area compared to Non IT, even i have my own independent house in Non IT area even though it is very close to city center, in terms of rental appreciation it is very less compared to Non IT area in fact during 2008 i had to reduce the rent for new tenant by 15% due to Recession.