Real estate: More space can space you out

In deciding to upgrade to a bigger home, don't allow optimism to cloud economic calculation.

I have seen many families upgrade to a bigger house. The reasoning was that the current house was a little small and a bigger house was the need of the current lifestyle.

In fact, some seem to be just upgrading because their friends and peers were.  Some buy a second house as they believe this can lead to tax savings, while some move from one part of the city to another to get a bigger space.

Vivek Ahuja is a friend who planned to move from a 2-BHK (bedroom, hall, kitchen) apartment to a 3-BHK apartment.

Though his annual income was around Rs 24 lakh (Rs 2.4 million), the property he planned to move into was around Rs 1.6 crore (Rs 16 million).

He had savings and investments of Rs 30 lakh (Rs 3 million), whereas his current house was worth around Rs 85 lakh (Rs 8.5 million).

However, there was a loan of Rs 45 lakh (Rs 4.5million) on his house, which meant that after clearing the loan , he would be left with around Rs 40 lakh (Rs 4 million).

This would mean Vivek would have Rs 70 lakh (Rs 7 million) to make a down payment and the loan he would have to take, considering stamp duty and other payments, would be around Rs 1 crore (Rs 10 million).

The house was due for possession in June 2010 and he had to make staggered payments over a period of time, most of which had to be done in late 2009 and early 2010.

When I looked at his cash flows, I told him, "Vivek, your surplus is just Rs 12 lakh (Rs 1.2 million) and you are not only wiping all your savings but also taking a liability which will drain your cashflows completely. Are you sure of what you are doing?"

He was calm and said, "My income is bound to go up and I will save some tax as well. I think it will be a stretch early on, but I should be comfortable in a few years."

He went ahead and booked his flat by making a token payment of Rs 500,000.

PRACTICAL ISSUES

Vivek then got his first shock when trying to sell his existing flat. A lot of buyers came in and saw and made him an offer of Rs 75 lakh (Rs 7.5 million).

This was Rs 10 lakh (Rs 1 million) lower than he had expected and he appeared stressed, as he had already stretched himself.

Luckily for him, a few months down the line, he was able to dispose his flat for Rs 95 lakh (Rs 9.5 million), as his society was in the final stage of redevelopment and some investor offered him this rate, thinking he would be able to make a quick buck.

However, others might not be so lucky, so, before you upgrade to a bigger flat, carefully evaluate the following questions and issues:

• What is the current realistic value of my flat?

• What is the cost of the new flat? Include parking charges, one time charges,brokerage, stamp duty, registration, society charges, water charges and others as well. Don't forget to note the cost of interiors and of furnishing the new house. This is often a significant cost and can scale up your budget beyond manageable proportions.

• Is there any tax liability at my end? This is also a cost. However, if there is any long-term capital gain on your property, this can be adjusted against the purchase of a new house, under Section 54 of the Income Tax Act, 1961.

• When will I get possession of the new house? How many months will the interiors of the new house take? Will I live in rented accommodation till that point? This is an important point and will depend on when you actually sell your old house. If you sell your old house first, you will have to go on rent, so that is another additional cost you must factor in.

• Do I have to wipe out my entire savings to upgrade to a new house? Not a prudent idea, as we live in a very uncertain world, where one must maintain a sizeable corpus from a contingency planning perspective. Ask yourself, "What will happen if I am unable to service the EMIs two years down the line. Do I have some back-up?" Hence, one must not wipe out all savings and investments to upgrade. Wait for a couple of years, till comfortable.

There is no standard answer to this one but most people will be better off selling the existing house first. This is because one will receive money upfront and there will not be much pressure on making payments.

If your financial situation is comfortable and you do not have a loan on the first property, you have the choice of living in your existing house and taking a loan on the second property.

The first house can then go on rent. However, if you have a liability on your first house, then you must sell this house first, clear the loan and only then take on additional liability to upgrade to a new house.

Finally, a house is a very emotional purchase but you must not allow emotion to cloud your economic judgment. Housing prices are at an all-time high and you would do well to defer this decision till these are more meaningful.

The writer is director, My Financial Advisor