A house is the most expensive purchase for most people. And since you intend to stay there for a long time, it is not uncommon to let your emotions score over fiscal prudence and buy an extremely expensive house. I must say it is unfair on my part to make such broad-based statements because this (the right cost of house for you) is a judgement call, and judgements are never objective.
Moreover, the incomes and cashflows are not stagnant, and the decisions you make based on current salary/income may look very conservative if your income goes up drastically in the coming years.
For instance, your current income is Rs 1 lac per month. You must choose between 2 houses, one in which you will have to pay an EMI of 40,000 and a second where you must pay EMI of 50,000. While you like the expensive house more, you settle for a cheaper house because you do not want your EMI to exceed 40% of take-home income. However, after a few months, you get an increment or switch your jobs, and your income goes to Rs 1.5 lacs per month. Now, 50K EMI looks quite manageable. And you feel you should have gone for the more expensive one. Such scenarios make decisions difficult.
Still, it is good to have a heuristic to keep your emotions under check or at least force you to look at things objectively.
In this post, we look at the 5-20-30-40 rule for home loans. I am sure many such heuristics are there, but I heard this in a brilliant podcast with Vishal Bhargava (recommended if you are planning to buy a property) and found it worth sharing.
What Is the 5-20-30-40 Checklist for Home Loans?
- 5: The cost of house should not exceed 5X Net annual income
- 20: Tenure should not be more than 20 years
- 30: You must make at least 30% down payment
- 40: Your EMI must not exceed 40% of the net monthly income.
How Does 5-20-30-40 Rule Help?
This basic rule helps you in assessing what you can afford and prevents overborrowing.
Let us say your net annual income is Rs 12 lacs.
5: The cost of house must not exceed Rs 12 lacs X 5 = Rs 60 lacs.
20: As you increase the tenure, the EMI goes down. Now, if you opt for say a 30-year loan, the EMI will be much lower compared to a 20-year loan and may give a sense of security. As the loan tenure is shorter, the loan gets repaid faster and you become debt free sooner.
30: 30% downpayment. So, if the cost of property is 60 lacs (as capped by Rule 1), the downpayment must be Rs 15 lacs.
40: The EMI must not exceed 40% of Rs 1 lacs i.e., 40,000.
So, if the cost of house is 60 lacs and the downpayment is Rs 18 lacs, the loan will be Rs 42 lacs. For a tenure of 20 years and interest rate of 9% p.a. (assumed), the EMI for such a loan will be Rs 37,788. Hence, such a property purchase will tick all the boxes.
Please note banks also take care of some of these aspects in some form. For instance, banks have internal credit policies about a cap on Fixed income to obligation ratio (FOIR). For instance, a bank may not be comfortable if the sum of all your EMIs (including the prospective home loan) exceeds say 45% of your net monthly income. Hence, such a bank will lend you only so much that your cumulative monthly EMI (across all loans) does not exceed Rs 45,000 (if your monthly income is Rs 1 lac).
By following this rule,
- You may avoid an impulsive purchase and evade overpaying for the property.
- You escape overborrowing.
- This provides you with some space for monthly investments which will be useful for other long-term financial goals.
- You have breathing space for additional loans if needed.
- You do not have to compromise (or have to compromise less) on your lifestyle. I understand this point may be slightly contentious because, for many buyers, a house is also a lifestyle statement.
- It is easier to manage shocks since the monthly commitment is lower.
What Are the Shortcomings of Such a 5-20-30-40 Framework?
Firstly, managing 30% downpayment can be a challenge especially if you plan to purchase in a big city.
Secondly, the downpayment requirement is not constant. It will keep changing as the property price changes. Continuing with the same example (where the house cost was capped at Rs 60 lacs), you need Rs 18 lacs for downpayment. You do not have so much money right now. You decide for wait for a few years and accumulate Rs 18 lacs. However, by the time you accumulate Rs 18 lacs, the property price has gone up to say Rs 70 lacs. So, now you need Rs 21 lacs for downpayment (as per 30% rule). Hence, by being too rigid with this framework, you just keep delaying property purchase and miss out on potential price appreciation.
Thirdly, your cashflows are also not constant. Your cashflows may improve as you get better work opportunities. You may get a bonus, using which you can quickly bring down the loan amount. By being inflexible with this rule, you may realize after a few years that you could have bought a relatively more expensive (or even desirable) house than the one you bought.
What Should You Do?
I think there is a lot of merit in following a rule-based framework like 5-20-30-40.
This can help you avoid big financial mistakes. At the same time, there is no need to be too rigid about this. You can relax considering your situation. Continuing with the same example of Rs 12 lacs annual income, this framework does not allow us to buy a house that costs more than 60 lacs. However, if you are optimistic (and this can be dangerous) about your job/income prospects, you can buy a slightly more expensive property and still be fine. You can do this with the downpayment requirement too.
At the same time, do not throw caution to the wind and discard the framework completely.