Come any RBI monetary policy meeting and all the financial dailies are replete with the news of the RBI going for an interest rate cut. The clamor for seeing lower rates is such that any outcome that isn’t dovish (soft stance on interest rates) is frowned upon by industry and consumer. Before you rejoice at the news of the rate cut thinking it will get you closer to your dream of owning a house or a potential reduction in the cumber some loan burden on your shoulders, we would like to throw some light on what really happens.
There is no denying the fact that when the RBI reduces the interest rates; the cost of lending for the banks reduces. But the underlying fact is that they should be willing to pass on the reduction to the borrowers. In some cases, they do pass on the benefits of such an interest rate reduction and it could aid overall cost of construction for the buyers. But does a middle class person gets closer to his dream with this 25-50 bps rate cut is the question? We try to find a correlation between the real estate purchase decision and RBI interest rate reduction through a simple example.
For the sake of understanding, we will assume a 30 year old man who wants to purchase a 1 BHK for himself in Mumbai at an estimated cost of Rs. 1 Crore. He would have to give 20-25% as down payment resulting in a loan amount of Rs 75,00,000. We will assume an interest rate of 9.5% for a base case scenario (which is Marginal Cost of Funds Based Lending (MCLR) and a spread which is levied by the banks depending upon the risk profile of the borrower and the loan tenure).
To make the analysis dynamic, we have considered three different income levels for the same individual. The take home salary has been arrived at after tax deductions and assumptions on PF and gratuity. In scenario one we can see that the person with the income level of Rs 10 lakhs per annum would not be able to service the loan amount within his retirement even if he uses his entire savings to fund the EMIs. At this income levels one can regularly service the loan only when the interest rates were to fall below 6%, assuming his savings remain constant. Even if the earnings profile of the person gets better, the inflationary pressures would eat up the incremental cash flows resulting into no material addition to his savings. Any 25-50 bps reductions in the interest rates brings a person in this income bracket nowhere close to buying a 1BHK at Mumbai, unless there is an unexpected windfall. The only option then is to buy a property in the outskirts of the city. However, the discomfort of staying so far from his workplace or main city may not fully compensate for the pride of owning a house at a better address.
If a person earning Rs. 20 lakh per annum was to go forward with the decision of purchasing a house his financial health won’t be encouraging either. This individual will be saving ~Rs 76280 per month after providing for all his needs and expenses to support his lifestyle. If he pays an EMI of Rs 63064 required to service the loan amount for a tenure of 30 years at an interest rate of 9.5% it will leave minor savings of ~Rs 10000-13000 a month. This puts him in the risk of a default in case a contingency were to arise as savings wouldn’t be sufficient to take care of it. Any 50 bps increase or decrease in the rate cut will hurt his wallet by ~Rs. 2200-2500. However, the amount is only 2% of his take home salary, and it would not alter his buying decision per say. This individual in absence of some unexpected windfall such as large bonus, increments or inheritance would have to live a simple life devoid of splurging or higher discretionary spending. Someone in this bracket can always be confronted by the question – is the vicious loan cycle worth it?
Coming to the third scenario, higher the salary, better it is for an individual to own a Rs. 1 cr apartment at Mumbai. In our example, the individual with Rs. 30 lakh per annum salary looks the best placed with him/her being least elastic to interest rate changes. The buyer in this case will have enough resources left even after servicing the loan. But the quantitative aspect which looks quite reasonable in the excel sheet may not be the reality. This individual may have elevated desires and would be looking for a 2 BHK or a 1 BHK in a higher priced locality. In either of these cases he will attract higher loan burden and hence higher monthly outgo. This individual might then face the same hand-to-mouth situation (a phrase often used by the salaried class) like the rest of the herd.
Interest rate can have a material impact if the quantum of interest rate reduction is higher than the rate of inflation resulting in increased savings. A 25.-50 bps rate cut isn’t material for a significant chunk of Indian population to make the big decision of buying a home. What we believe is that the salaries (trajectory) and aspirations (and sometimes emotions) have a better role in deciding investment decisions in real estate than the range bound interest rate alterations made through the monetary policy changes. Also where both members of a family are working and can contribute to expenses of a family and asset ownership, things look a little better.