Property has a special characteristic among all investment mediums, giving it a unique position in the hearts and minds of many. Studies time and again, including this one from Harvard has highlighted the fact that homeownership has stronger associations with feelings such as, being in control of one’s living situation, the desire to put down roots in a community, and most importantly, the sense of success that comes with owning. With constant reminders from the real estate industry, and with the help of the media, these personable characteristics sometimes outweigh the rational fact that property has inherently poor qualities as an investment vehicle.
Here in Asia, homeownership is still the preferred method for individuals to build wealth, and is so effective primarily because of the “forced savings effect.” So long as the “buyer” is able to service his payments for the duration of his loan tenure, he will usually come out on top financially, compared to the “renter”. However, this is because generally most “renters” do not have a clear goal or an automatic savings mechanism. Because the “forced savings effect” is in play for all buyers under all conditions, it is one of the main reasons why “buyers” build wealth faster. To be clear, our discussions forward would be primarily for buying-for-own-stay, and not for investing. We are assuming that the property would not be generating anything for you except capital appreciation.
Buying is not always better, simply because, apart from incurring the high, actual, monetary, costs of borrowing when entering a mortgage for a property, there is also the higher, qualitative, abstract, opportunity cost, which is incurred when we decide to buy a property. The oppurtunity cost takes with it all the benefits of renting, which is often underappreciated by our capitalistic society.
“Renting is just throwing money away”
Theoretically, the amount you spend on rent could go towards a mortgage for your own property, thus the origin of the saying. If we were to break the argument into pieces, it would go something like this -
- When you buy, X% of your monthly repayments go to your house
- When you rent, Y% of your monthly repayments go to someone else’s house
- X is probably not much more expensive than Y, not that I cared enough to really find out.
- Since we’re paying anyway, might as well pay for our own house!
- Conclusion! Buying is better than renting.
The logic presented above is incomplete, because it failed to recognize the cost of borrowing.
There are four parts to your housing loan, which consists of Principal, Interest, Tax, and Insurance; and the chart above shows you their approximate portions. The Principal (P) is the only chunk of the four parts which contribute towards your house, while the rest (interest, tax, insurance) are costs of borrowing - which are expenses.
When you take into account the expenses involved in borrowing money, one can easily see that engaging any bank for a loan involves "throwing money away". - Why you ask?
Because when you borrow RM250k for a house worth RM275k now, you’re actually repaying RM450k to the bank in 30 years. The extra RM200k – give or take - consists of Interest, Tax, and Insurance, which is classified as the costs of borrowing.
When the costs of borrowing meet the concept of amortization, this is when things start to get really hairy. The total amount of interest payable for the loan is added to the principal, and then divided into equal repayments over the term of the loan.
The graph above shows a table repayment structure, which is how the amortization schedule breaks down your payments into interest and principal respectively. For the first 10 years, you’re going to be paying into them at a ratio of roughly 20% Principal, 80% Interest. As time progresses, the ratio contributed into interest and principal respectively, reverses; meaning that the last few payments 30 years later will be mostly going towards the principal. The chart tells you several things, but the first one you should notice is that your monthly repayments will be mostly going towards interest, at least until half of the loan's duration elapses.
For illustration purposes, we’re going to be using an imaginary couple named Adam & Cat.
Adam is 28 and recently married Cathererine, who thinks that they should get a house since they’re starting a family soon. After saving up for some time, Adam walks into an agency and plonks down RM25k for down payment on the dream 2-bedroom unit priced at RM275k. He did his homework, got fair rates, and the amortization schedule below outlines a very typical housing loan by a local bank. We also factored in approximations for quit rent, assessment tax, and maintenance fees.
Notice that the majority of your first payment really goes towards satisfying the interest you owe to the bank. The ratio between principal and interest adjusts throughout the life of the loan, where payments toward principal will increase, and the interests repaid will decrease.
5 years later at your 60th repayment, you’re still paying more interest than principal, per month.
Things eventually even out 15 years down the road. Note how half the loan duration has passed, but the amount owed remains over 65% of your initial loan amount.
At the end of your 30-year loan, you would have paid roughly an extra 80% of your principal as cost of borrowing, on top of your 100% principal sum. Thus when you sign a mortgage, what it really means is that you’re telling the bank, “Hey, you wanna buy the house for 450k? It’s worth 275k now, but if you let me use the house, I’ll pay you back 450k later."
Of course, this is not the whole story. Property appreciates, and the Housing Index in Malaysia has averaged an annual +3.93% from 1997 until 2015. However, the spread is huge. The Housing Index reached an all-time high of +44.50% in the first quarter of 2000 and a record low of -39.20% in the third quarter of 1998.
Assuming times are average and nothing really bad or good happens, Adam would have turned a tidy profit from the sale of the property, 30 years later for an approximate selling price of RM550,000. Of course, this is assuming that Adam was able to make monthly repayments without fail for 30 years (360 months). Should the repayments stop coming in, the Bank forecloses your property and recovers whatever is owed to it.
In short, here are the major Pros and Cons of buying a property (as opposed to renting)
As the “savings” come in the form of mortgage repayments, there is very high incentive for the borrower to continue with his payments. And this will bring about the forced savings effect, where the home-owners really “dint have much of a choice”, which is why it works. Effectively when you buy a property, you're choosing the bigger piggy bank, requiring more attention and effort to satisfy.
The “buyer” is probably going to be better off than the “renter”, financially, 30 years down the road. Statistics and historical averages side with the buyers; so long as the monthly repayments come in, capital appreciation on the property will very likely outpace the costs of borrowing before the tenure ends.
This is based on numerous assumptions, including average market conditions, fulfillment of mortgage terms, the lack of a real financial plan on the part of the "renter" and the constant earning ability of the buyer.
You can decide for yourself how foreseeable are those assumptions.
- Greater Privacy / Control
You won’t have anyone you don’t want on your property. Your privacy is protected by laws against trespass, and you would have more freedom than the “renter” whom has to occupy the home subject to the terms of the tenancy agreement. You are free to do whatever you want in your own space, protected by the right of quiet enjoyment. You can set the place up to complement whatever activity you desire, and a "renter's" enjoyment can be hampered by a landlord's restrictions or restrictions in the land itself.
The costs of borrowing is approximately 80% of the principal for Adam in the example above. Before your payment of the first instalment to the bank, on paper you are already in neck-deep debt. The risk falls almost entirely on the buyer, as banks hold your property as security for the mortgage. Even assuming that payments are made orderly throughout the tenure, the property itself must appreciate in value for the buyer to recoup his expenses to the bank as costs of borrowing. Nobody can tell you what the market will look like in 30 years; and at best, it is an educated guess.
Most of the risk lies with the purchaser, as the bank can foreclose the property in case of default, and normally recoup most of its receivables.
It is a thin line (if any) between a mortgage and a debt, and as I feel Mr. Clark infinitely more eloquent than myself in the description of debt, so here’s a quote from him:-
“Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.” -- J. Reuben Clark
Unlike renters, owners bear this burden. Assessment taxes, quit rent, utilities, repairs, maintenance of property, are all costs of ownership, which can be avoided simply by not owning. You won’t be breaking a sweat when the fridge breaks down or when you uncover termites in the woodwork.
The real cost of ownership is the maintenance of the property throughout its days. A diligent owner would keep problems in check, nipping them in the bud and preventing them from manifesting into bigger problems; a sloppy owner would be unaware when things fall into disrepair, and avoid repairs until the damage cannot be ignored.
You’re going to have decide which kind of owner you’re going to be, and if “owning” is for you.
Do the math! Let someone you trust do the math, if you can't.
Stamp duties! Legal Fees! Lembaga Hasil Dalam Negeri and CKHT Forms! RPGT! 2% Agent Fees!
RPGT places a 5-year “lock” of sorts on all transacted property which was introduced by the central bank as a measure cooling the property market. Persons selling before the 5 years is up would incur a tax, payable to the Inland Revenue Board (LHDN). Stamp Duties cost you percentage of the property, lawyers charge an arm and a leg, and if you use an agent, he will get his cut.
If only we can move our house everytime we wanted to move...
Transacting a property has many inherent costs that make owning one a hassle if you need to get rid of it quickly. If you got a new job at another part of town, you’ll have to deal with a longer commute instead of just moving. If your move is urgent, devious buyers can leverage that into a lower price.
Renters on the other hand, only have to deal with the matter of their deposits. If they're willing to forfeit the deposit, they can probably be packed and out the door in 20 minutes.
Here are the tough questions we would ask when deciding to buy or rent...
- Do you foresee yourself settling at the location for the next 5 years?
In the fast paced world today, can you really see yourself in the next 5 years? Is this the place that your heart truly wants to settle down? Do I foresee someday when this house I bought might be a hindrance?
Properties sold after 5 years are exempt from RPGT, giving you a better chance of recouping your costs of borrowing and potentially. making a tidy profit on the capital appreciation.
- Are you good at making monthly repayments?
Past behaviour is the best indicator for future behaviour. But when we talk about a mortgage, consistency is everything. Be truthful with yourself and your finances, are you the kind of person who don't periodically fall behind on payments, and can you afford it? Do you have self-control problems? Taking on a debt you are not confident in repaying, is a very bad idea.
- Although buying is overrated, it's still a pretty good idea to buy.
Historically, capital appreciation on properties has kept up with inflation - that offers some level of certainty with regard to apprecation, making property purhases pretty safe.
Capital appreciation on properties has historically been 1% ahead of inflation, and this is one of the reasons why many feel that property is a safe investment - because it keeps up with inflation.
Learn about property cycles and decide for yourself if it is the time to buy. You are going to live with the decision of buying, don't let anyone else make it for you.
- If you need to borrow, fight for the best rates.
Banks make a boatload of money, I think we can all agree that there is little need to fatten their coffers further. A 0.05% difference on a RM275k loan would amount to RM2685.6 over 30 years. A little planning would really go a long way. Go to bankers, be pleasant and leverage on your credit rating; if you have a good score it is not unheard of to get reductions up to 0.15%
Bank Negara introduced the Reference Rate Framework early 2015, which comes with revised rates for the commercial banks. A few good samaritans in the finance industry have released this list, which outlines the Base Rate (BR) at which banks borrow from the Bank Negara, and the banks’ respective Effective Lending Rates (ELR) for individuals looking for 30-year RM350k loan with no lock-in period. This list is a godsend for buyers looking for the best rates.
If you anticipate having spare cash at hand in the future, Flexi loans would allow you to save some interest by parking “spare cash” which reduces your interest payable. If you don't know about them, learn more about Flexi Home Loans at iMoney.
- Remember that Less is More
The less time and resources you sink into your dwelling, the more time and resources you have to live life, to its fullest.