Why buying a plot on loan is a bad idea

Investing in real estate is more emotional than a financial decision.

The land is always treated as a prized asset because it is limited in supply. Many people invest in real estate through different means such as plots, individual houses, commercial complexes or apartments,to achieve their financial goals.

Properties like apartments, individual houses etc., are high-value investments and may not be suitable for small-time investors. Such investors usually opt to buy plots of smaller sizes, which they hope to sell on appreciation or whenever they need money to meet their goals.

Plots costs around 20-30% of the cost of house construction or an apartment. Also, many buyers invest in plots with the hope of constructing a house at a later date.

To facilitate plot purchase, most banks and Saccos offer loans to buyers. Though the land loans or plot loans are similar to home loans in tenure, interest rate and processes, there are many differences in terms of tax benefits, the quantum of loan approved and tenure.

But how beneficial is for a person to buy a plot by availing a loan? Is it worth borrowing money on interest to buy a plot? Let us first understand the difference between a home loan and a plot loan.

Plot Loan Vs. Home Loan

Home loan is usually considered as ‘good’ debt by many people because of the following:

Tax Benefits

The interest and principal paid on home loans are eligible for tax exemptions. So, many people prefer to reduce their tax by investing in apartments/individual houses by securing home loans.

Plot loans alone, are not eligible for any tax benefits. However, if you construct a house on the plot by availing a construction loan, you will be eligible for tax deductions.

Lower Loan To Value

Most financial institutions sanction home loans up to 80% of the total cost or the loan eligibility of the buyer, whichever is lower. Depending on the cost of the house, sometimes the financing can go up to 85% -90% of the total cost.

When you buy a plot through a loan, most financial institutions sanction loans up to 70% of the plot value. So, a buyer has to arrange for the remaining 30% of the cost.

Restrictions on the Type of the Property Purchased

Home loans are given for buying/constructing houses irrespective of their location. You can even avail home loan for construction in your ancestral village or to construct a house in the agricultural land also. Home loans are also provided for house reconstruction or to build additional floors on the existing property.

Plot loans are provided only for the purchase of residential plots. Such loans are usually provided for plots within the municipality or corporation limits. You cannot buy agricultural land or plantation or land in a village by availing a plot loan.

As you can see, a plot loan has many disadvantages over a home loan, although both are given for property purchase.

Many land developers insist that even though plot loan has no benefits, the land value will always appreciate and ample gains can be made by buying now and holding for a longer time. Also, as land is a tangible asset, there is no possibility of losing the amount invested.

But how prudent is it to take exposure to real estate asset class by investing in plots through loans? Do the returns really match the interest on the loan?

If you compare land with mutual fund, you can observe that investing the amount in a SIP of a balanced mutual fund yields better returns. Even though both assets are assumed to yield the same return of 10% pa over a period of 10 years, the returns on the plot is reduced because of the interest. Also, she has to bear the cost of down payment as well as the cost of registration, brokerage, loan processing charges etc. The actual return is reduced to 2.27%.

Also, the capital gains arising from real estate is taxed at 5%. Hence, the post-tax gains from the plot will reduce further. 

Apart from the disadvantages of availing a plot loan and the negligible gains obtained, there are many other factors to be considered before investing in a plot.

1. Real estate is a highly illiquid asset class, and it may not always be possible to find a buyer at the need of the hour.

2. You have to double ensure that the land you plan to buy is free from any litigations and all the documents are in order. Due diligence from a legal expert is a must before any property purchase. 

Read – Official Process and cost of buying or selling land in Kenya

Excepting a case where you want to build your own home, investing in a plot by availing a loan is not a prudent investment decision. It is better to invest your savings in a financial asset regularly.

Source: Money Sage