Building on solid ground

Recently, Siddharth Sarin (name changed) and his wife booked a flat in an under-construction building in suburban Mumbai. He then started scouting for home loans.

Talking to the banks and the builder, Sarin realised that he had two payment options. He could either pay the builder all the money for the house upfront (referred to as the advance disbursement facility) or he could pay the builder as the construction progressed.

If Sarin opted for the first, the builder was ready to throw in a discount which he lost if payments were made in stages. The banks Sarin spoke to were aggressively pushing advance disbursements. But Sarin wasn't sure what to pick.

It's a dilemma that many home buyers are facing today. With competition, banks and home finance companies have been hardselling these facilities, to prop up their disbursal figures. What does this mean for the buyers?

Your decision to go in for the advance disbursement facility should be based on several factors. It all depends on your current finances, whether you are currently paying rent or have an existing equated monthly installment (EMI) till the time you get possession, and your risk perception regarding the builder and interest rates.

Your best yardstick is to equate the discount you will get vis-a-vis the interest you will have to pay till you get possession.

For example, you buy a house for Rs 30 lakh at a fixed rate of 7.5 per cent for 20 years. The flat is under construction and will be ready for possession in two years.

Say, if you pay upfront, you get a discount of Rs 2 lakh (the assumption is that while giving the discount the builder has considered a 12.5 per cent interest rate for funds received upfront). Now the price tag for your house is Rs 28 lakh.

Now, compare it with the interest you pay on the full loan taken upfront over a period of two years. At 7.5 per cent interest, it works out to Rs 1,73,124 to the Rs 2 lakh discount you get.

While you are the winner in this mathematical example, that may not be the case in real life. Builders will rarely give you discounts that are larger than the interest you will pay till possession.

But it's not just the discount versus interest paid. There are additional costs like the stamp duty and registration that should govern your decision.

If you are taking possession a year later, a small trigger could be that advance disbursal will knock 12 months off your repayment schedule while waiting for the house to be completed.

So if you've taken a 20 year loan, by the time you take possession, you will have already paid off one year's loan and interest.

Says a Mumbai based builder, "The countdown to your actually owning the flat begins the minute you pay upfront, regardless of whether you are staying in it or not."

It also has its downsides. Most importantly, unlike what builders and banks would have you believe, there are no tax benefits on purchasing under construction houses with borrowed funds.

In the sense that you can claim the benefits on the interest component already paid till you get possession over the next five years, as long as the benefit doesn't exceed Rs 1.5 lakh a year.

If you've taken a loan above Rs 20 lakh (at 7.5 per cent, a year's interest will work out to roughly Rs 1,48,480), you will be exceeding that benefit. In other words, you will lose the tax benefit for the amount you paid before possession.

The Income Tax Act clearly states that the benefit can be spread across five years, but with the Rs 1,50,000 cap in place, the chance of you being able to see the benefits across five years is impossible. Says Kamlesh Vikamsey, partner, Khimji Kunverji & Co, a Mumbai-based accounting firm, "Because of the cap, unless the discount exceeds the interest paid, it doesn't make economic sense." In larger cities, where housing is expensive, people with larger loans will be affected.

The biggest risk is committing yourself financially to an asset that still doesn't exist.

Since real estate is still a highly unregulated and unorganised market, there is no way to judge the credibility and financial standing of the builder "" the two things that will determine the project gets completed on time.

Says Suresh Menon, general manager "" Mumbai region, HDFC, "Consumers looking at the advance disbursement option must clearly understand the risks involved in the deal before signing up for it."

The risks range from the lack of approvals and necessary permissions from local authorities to a rise in input costs which the builder is unable to bear. There is always the chance that a change in local laws regarding buildings takes place adding to delays in project completion.

What happens when property prices fall tomorrow? Says Rajiv Sabharwal, general manager, ICICI Bank, "Advance disbursals is a risky proposition so we don't offer the facility to all builders. The decision is based on the builders' past history and financial capability."

Now, consider what happens when you opt for partial disbursements in stages. You will be paying the bank a pre-EMI. In the case of the pre-EMI, you can claim upto 20 per cent of the amount paid over the next five years.

The pre-EMI will be a lower burden because it will be calculated on the amount paid at each stage rather than the full loan amount. But if interest rates change, then they will vary at each stage of the disbursement.

Say if you take a Rs 10 lakh loan in two tranches of Rs 5 lakh each. If you opt for a fixed rate, which say is seven per cent today, the first tranche of Rs 5 lakh will be disbursed at this rate.

Six months later, when you need the next tranche, and if rates have gone up to eight per cent, the second Rs 5 lakh tranche will be disbursed at eight per cent.

If you are on a floating rate and rates go up, your entire loan will be at a higher rate and vice-versa if they head south.

So what should one do? Research the builder, find out whether possession for past projects happened in time and weigh the costs against the benefits.

As a rule, avoid builders who are fairly new or projects that take more than 18 months for completion, and avoid getting into deals where the necessary approvals or papers aren't easily available. It's better to have a safe investment than a sorry one.