Edit 1 - Added excel calculator at the bottom
Happy New Year everyone!
I recently purchased a house, and thought I'd share the framework I found useful when evaluating how much I can afford. It's inspired from a post by Subramoney.
When buying the house, it was important for me that it did not impact my other goals like retirement and my daughter's education. I also really did not want to get into an unsustainable situation where I'd have no money left by the end of the month. So I followed this 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:
One big caveat to these numbers is that I'm selling the house we live in, so we were able to afford the new house we're buying.
Without selling the house, the numbers look like this (Assume my take home pay is X):
P.S: Excel calculator if you don't want to do the math (it's view only, so make a copy to try it out): link
Happy New Year everyone!
I recently purchased a house, and thought I'd share the framework I found useful when evaluating how much I can afford. It's inspired from a post by Subramoney.
When buying the house, it was important for me that it did not impact my other goals like retirement and my daughter's education. I also really did not want to get into an unsustainable situation where I'd have no money left by the end of the month. So I followed this rule:
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
One big caveat to these numbers is that I'm selling the house we live in, so we were able to afford the new house we're buying.
Without selling the house, the numbers look like this (Assume my take home pay is X):
- 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.
- 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.
P.S: Excel calculator if you don't want to do the math (it's view only, so make a copy to try it out): link