Since the time I have started writing this blog, I have interacted with many people who are very proud of the assets that they own. These can be financial assets such as Stocks, Bonds or MF units. These can also be real assets such as a car , a house, Land etc. The one thing which nearly always surprises me is that how many of them do not understand a fundamental point about owning an asset – you really own an asset only when you have paid up in full for it.
Now many of you think that I am nit-picking here. After all even if you have bought a home by taking a hefty loan, the home is in your name, right? You are staying in it and can rent it out tomorrow if you want to. So why do I say that you do not really own it? OK, let us take a simple example to illustrate my point. Let us say you have recently bought an apartment that is priced at 80 lacs. You funded it with your own resources to the extent of 30 lacs and the rest was taken as a loan from the bank. I hope most of you know that the house is now held by the bank as a collateral, till you are able to pay off the entire 50 lacs loan. In fact, should you fail to do so, the bank is well within it’s rights to sell off the house in an auction and claim the 50 lacs plus any due interest from the proceeds of the sale. Obviously, if you really owned the house this will never happen.
So in reality, if you own a house which has a bank loan funding it, what do you own? Well, you do own the house partly, to the tune of the amount of money you have contributed towards the cost. In the above example, you paid 30 lacs out of 80 lacs so you own 37.5 % of the house to begin with. Now as you keep paying your EMI every month, your ownership of the house will keep increasing. Keep in mind though, in the first few years the rate will be slow as much of the EMI amount goes towards the interest component. So if the house price remained constant and your loan tenure was 20 years, you would approximately be adding to your ownership by 3 % every year.
Now, the good thing in our country is that the prices of real estate generally go up over time. Thus when we are looking at house ownership, the right aspect to consider is the worth of your holding rather than your % holding of original price. Let me make this clear by using the same example:-
- Let us say in 10 years the price of the house has gone up to 1.4 crores.
- Total amount paid off till 10th year is 60 lacs (say)
- Outstanding loan to the bank is still 60 lacs ( with interest )
- So your equity in the house now is 80 lacs. In reality it is more as you can pre-pay.
- So with an appreciating asset where the rate of appreciation is greater than the interest rate it will in general make sense to get the asset on loan, even though your ownership of the asset is limited.
So is the home loan a “good loan” then as many people say? Not really as you end up paying about 1.2 crores for 50 lac loan and get full ownership of your apartment when it is 20 years old !! Your family may have been pushing you for years by then to get a newer apartment. In reality all loans are avoidable – they are however imperative at times simply as you do not have adequate money to cover for the asset. In such an event, take the loan but pre-pay it as soon as you can.
Now look at a situation such as a car where the asset is a depreciating one. Here it makes very little sense to take a loan as you will probably be still paying your EMI by the time you start thinking of getting a new car. If you assume the life of a car to be 10 years then under no circumstances should you look at a loan tenure of more than 5 years. And if you are the kind of person who wants to change his car every 5 years, then forget about loans and think of buying a car only when you are able to pay it off in full. A direct follow up from this will be this – never take loans for anything whose life is less than 5 years.
Asset ownership makes us feel good but we need to be clear about the affordability of it. For long term assets we can look at our long term earning potential and take a long term loan, with the knowledge that our asset is quite likely to appreciate. However, for assets with short life such as a smartphone, we need to be able to afford it today.If you have to buy it on loan and know that you will need to replace it after 3 years, then you really cannot afford it.
Think about what you just read and look back on some of the last few asset purchases that you did. You cannot change those now but you can make sure that in future you are buying assets that you can truly afford.