A financial framework to purchase your home
Helps you avoid sleepless nights and financial ruin
Hi!
Last week I talked about why I bought a house. The logical thing to do when buying a house is to do it near retirement. You’ll buy a house that will fit your needs in retirement, and in the place you will retire at. You’ll also be able to save for a long time to pay for it in cash, and avoid putting yourself in debt. But we’re not robots - life’s too short to be stuck making logical choices all the time.
Let’s say you’ve ignored all the logical advice (like I did) and want a house today. You could pool all of your savings for a down payment, get the largest loan you can service and get that dream house. But that’s a recipe for financial stress and probable ruin. I found a nice post from Subramoney which takes a conservative route to determine if you can afford that house. I’ll summarise the rules of thumb, and talk about how my purchase fits into it.
The 3-20-30-40 rule
The rule is inspired by the home loan processes in the 1980s, where banks would evaluate customers based on this rule to determine if they were eligible for the loan they were asking for. Modern lending processes have become much more lenient, but evaluating yourself by the 3-20-30-40 rule helps avoid financial stress when servicing the loan.
The 3 in the rule limits the total cost of your loan. The loan principal must not cost more than 3x your in-hand family income. If you’re buying a house which is under construction, add another 10-15% to the cost of the house for interiors and then evaluate. When you’re just out of college, you might be earning in the region of 10LPA which means you’re not allowed to get a loan for more than 30L. That’s usually not enough if you’re buying your first home and don’t have any savings. So don’t have FOMO and wait for a few years for your income to increase before looking for a house. There are plenty of houses in the market.
The 20 stands for the maximum duration of your home loan. The home loan must not be for more than 20 years. Banks now give loans upto 30 years which can reduce the monthly EMI, but you will pay over 2x the house cost just as interest by the end. Or another way of putting it - The home loan must be fully paid off in 20 years. This gives some leeway to have a lower EMI, and whenever you get any lump sum amount, you can pre-pay your loan to reduce interest.
The 30 is the maximum percentage of the EMI. Your EMI (including all other EMIs) must be less than 30% of your take-home income. So if you earn 10LPA in hand, you must limit your annual EMI to 3LPA. With the current interest rate of 8.5%, that translates to a maximum loan of 29L. That might not get you a house in the city of your choice, so it’s better to wait till your income increases.
The 40 in the rule is the minimum down payment for the house. Your downpayment must at least be 40% of the cost of the house. These days the minimum downpayment is 20%, sometimes even 15%. This increases the loan amount, and overall interest paid. Win for the banks, burden for you. It’s better to save up for some time and then pay a large amount immediately to reduce the overall interest on the loan.
So summing it up - let’s take the case where you’re earning 10LPA in-hand:
The maximum loan principal is 30L.
The maximum loan tenure is 20 years.
The monthly EMI comes to around 3LPA for 8.5% interest.
Since the loan can be max 60% of the cost of the house, you can get a house upto 50L. So you need to fund a minimum of 20L out of pocket to get the house.
Using the rule for my purchase
We had the means to fund the house primarily out of pocket, but that meant liquidating everything we had for retirement and my kid’s college expenses. We weren’t comfortable with that. So we decided we’ll take a larger loan, but prepay it so that it closes quicker.
Both my wife and I earn, but for this case we decided to take just my salary to be doubly comfortable. Let’s say my annual take home pay is X. Plugging into the rule:
3 → We took a loan of 4X my take-home pay.
20 → We took a loan of 30 years
30 → The EMI comes out to around 38% of X
40 → We are paying 25% as down payment.
Yep, missed on all of them. But here’s the thing missing in the numbers - we are planning to sell my wife’s house which we currently live in. We don’t know how much it’ll sell for, but it looks to be around 2.8X. My wife and father-in-law co-own the house, so we might get 1.4X to pre-pay the loan. This changes the numbers a little:
3 → The loan principal is 2.8X
20 → The loan will still be for 30 years, but we’re planning to pre-pay within 20.
30 → The EMI comes down to 28% considering 20 years repayment
40 → We’re effectively paying 50% as down payment.
This will not happen immediately. We’re still living in the house, so we most likely won’t close on the sale till the new house is ready (which will take another 3 years). We still have some risks where the house might not sell considering there are new constructions popping up everywhere in my city. Or we might have to sell it at some discount to get quick liquidity. That’s why I don’t consider it into my numbers yet while things are still up in the air. I’ll provide updates when they happen.
Wrapping up
Like I mentioned before, buying the house was a purely emotional purchase. We planned a bit so that the finances are comfortable for us to sleep peacefully at night, but things are still uncertain. We’re okay with the uncertainty though, because we have a retirement cushion to withdraw from in the absolute worst case. That’s a major advantage to buying a house later than immediately after college.
If you’re considering purchasing a house, try to fit it into this framework. I think that it allowed me to purchase a house without significantly impacting my stress and quality of life. It might do that for you too.
If you already have a home loan, does it fit into this rule? If not, how have your finances changed to accommodate it? This is my first house, so I’m curious to hear from you and your perspective. Please let me know in the comments!
Until next time!