Is home loan leverage or liability?

The housing market in many countries is dependent upon what could be easily termed as a loan economy. India is no exception. But how many of the home buyers even think whether a housing loan is leverage or liability for them. The ground reality is that many of them don’t even understand the difference between leverage and liability. The traditional education system has not taught us to differentiate between good debt and bad debt? A good debt is one where you earn more with the borrowed money than the interest being paid. On the contrary, a bad debt is one where the interest rate is higher than earning, if there is any.

So, an average person has to pick wisely whether a debt is his ally or enemy. The question that also needs to be assessed is whether a house on loan has asset capacity to deleverage one’s financial obligations in the wake of an emergency. If one’s home loan is just a function of future earning potential, then it could be a liability with potential to destroy one’s life in case of an emergency.

The relevant question is whether one should buy a house on loan. But most people asking this already have an opinion on this. All that they need is a confirmation bias from an expert on this subject matter.

Personal finance cannot be one-size fits all. Whether a home loan is a leverage or liability depends upon the borrower. It would be a very generic statement to say that a property with borrowed money is a leverage. The same goes true with the generalised statement that housing appreciation being lower than interest paid makes a lousy financial choice. These are lazy answers to a complex problem.

Say for instance, someone having Rs 1 crore in his investment portfolio that earns him 14% per annum takes a home loan at 8.5% interest rate. Now, with an interest arbitrage of 5.5% in earning and debt payment, this would qualify as leverage. But the same home loan at 8.5% interest could be a liability for someone if the given property is his only asset and the said property is appreciating at a nominal rate of 6-7%.

A lot of financial experts even believe that instead of paying 8-8.5% interest to the bank, it would be prudent to stay on rent in the same house with 2-2.5% payment and the rest could be invested in a high appreciating asset. This could enable the person to buy the same house without any home loan in the next 10-15 years, depending upon the returns.

The game of leverage and liability is not limited to just the financial calculation. It is much more for an average salaried middle-class Indian. The cultural belief in this part of the world is that a house is the biggest social security. But, if a house on loan is the only social security with you, this psychological security won’t help you in any given emergency.

For instance, if there is a medical emergency in your family that needs large capital after 4-5 years of buying a house on loan. Does your house have the asset capacity to bail you out? If you wish to liquidate the said property in urgency, it would mean a distress sale and would fetch a lower price than the prevailing market price. Mind you, the EMI that you have paid to the bank in the initial few years of property acquisition is mostly the interest paid and not the principal amount. So, in your final calculation there could be a potential situation where you need to pay more to the bank than what the current selling price of the said property is. So, this kind of loan is a liability.

Calculation table

“Does it mean that one should not buy a property on loan,” questions Nitish Shastri, a financial analyst. According to him, if one has a net-worth and exposure to other liquid asset classes that can take care of your emergency needs, then the home loan is a leverage. One is earning higher with own money than what he is paying to the bank for borrowed money. More importantly, a piece of property is your risk mitigation strategy and you are not putting all your eggs in one basket – be it stocks, mutual funds, gold or real estate. In such a scenario, property being less volatile, compared to financial assets, is a prudent financial decision.

“So, it all depends upon the profile of the borrower that defines whether a home loan is a leverage or liability. While it is a leverage for someone having a net-worth, it is definitely a liability for someone not having any financial back-up plan and having bought a house due to cultural conditioning. One slogs the initial 10 years of his professional life to save the 20% down payment amount and then further slogs for the next 20 years to repay it to the bank. Customer enablement with home loan is a smart strategy only for the banks and the builders,” says Shastri.

Rikky Dua, a tax consultant says the fundamental question is who is an ideal candidate for buying a house on loan. According to him, in an ideal condition a person who can serve his EMI with the passive income generated from his other investments is the ideal case study of leveraging a loan.

“Unfortunately, this is not the reality of a vast majority of Indians. Several studies have shown that 98% of urban salaried middle-class Indians don’t have any social or financial security. They are mostly living a pay cheque to pay cheque life; and more often than not are just one step away from a medical or legal disaster in life,” says Dua.

What makes the case of home loan borrowers even worse is the absence of financial education in this part of the world. Several studies have shown that most of the home loan borrowers don’t even understand the terms and conditions of the loan. They don’t understand that the banks mostly deduct the interest part first in the initial few years and keep the principal intact for the later part of loan repayment. Understanding of prepayment fee or penalty is also limited. Very few home loan borrowers even negotiate the prepayment fee, if they get some money to prepay the loan, and prepayment penalty is often as high as 6%.

The statement of people falling into a debt trap with home loans is not 100% true, it nevertheless is a reality. Home loans are no doubt the cheapest loans available in the market. And the whole argument of loan as leverage or liability is not black and white situation, it’s actually grey. But for those who don’t understand the financial game of leverage and have just started earning, a home loan is not just a liability but a potential debt trap.