Why it is essential to plan a home purchase?
Home is one among the biggest personal purchases one makes in a lifetime.
Hence it is only prudent to plan it immaculately before committing any cost.
Why immaculate planning is necessary? Because we are dealing with a lot of money here.
In this article we will discuss how a common man can plan a home purchase.
But before we go into the details, it is essential to remember a basic concept first.
“We cannot overspend on anything.”
Let it be grocery purchase, clothes, gadgets, education, healthcare, or home, we cannot afford to overspend.
Overspending is a curse that puts our financial position in jeopardy.
Hence, it is essential to engrave in our mind that, just for the purpose making ourselves feel better, we cannot overspend.
So now, lets see the rules using which one can effectively plan a home purchase.
#Rule-1. Never overspend on home.
What is overspending?
Suppose my monthly budget for household grocery was Rs.25,000. But I end up spending Rs.26,000. This is overspending.
I overspent my budget by Rs.1,000.
In terms of grocery purchase, a clear monthly budget defines if there has been overspending.
But in terms of home purchase, setting-up a budget is not as simple.
There are two methods one can use to estimate ones budget for home purchase:
- Net worth method, or
- Monthly income method.
#1.1 Net Worth Method
Supopse there are two individuals, Raj and Ram. Both of them decided to buy home for self.
The value of house they selected for themselves are as below:
- Raj : 2Bhk Flat @ Rs.50.0 Lakhs.
- Ram : 2Bhk Flat @ Rs.5.0 Crore.
From these values, what do you think who is overspending?
As Ram is buying a property which is 10 times the value of Raj, hence it looks obvious that Ram is overspending.
But before concluding, lets check another data:
- Raj : Net Worth (Rs.10 Lakhs)
- Ram : Net Worth (Rs.11 Crore)
[Note: what is net worth? Value of those assets, whose net cash flow (cash-out minus cash-in) is positive]
How these flats value in terms of Raj’s and Ram’s respective net worth?
- Raj – Ratio: 5.0 (50L flat’s value/10L net worth)
- Ram – Ratio: 0.46 (5Cr. flat’s value/11Cr net worth)
What does it mean?
Compared to their Net worth’s, Ram is buying a home which is 46% of his net worth.
Raj is buying a home which is 500% of his net worth.
So who is overspending? It is Raj who is overspending.
Rule of Thumb: Plan a home purchase such that the value of home is not more than 0.5 times your net worth.
This method can be used by middle aged people planning to buy a home.
Younger people can use the next method…
#1.2 Monthly Income Method
Lets use a similar example again.
Two individuals, Jack and John. Both of them decided to buy home for self.
The house they selected for themselves were as below:
- Jack : 2Bhk Flat @ Rs.50.0 Lakhs.
- Loan Tenure : 15 years.
- Interest : 8.5%
- Estimated EMI : Rs.40,000/month.
- John : 2Bhk Flat @ Rs.5.0 Crore.
- Loan Tenure : 15 years.
- Interest : 8.5%
- Estimated EMI : Rs.3.95Lakhs/Month
Their monthly income is as below:
- Jack : Take home @ Rs.85,000.
- John : Take home @ Rs.5.0Lakhs.
How these flats value in terms of their respective Net incomes?
- Jack – Ratio: 0.47 (40K EMI /85K income)
- John – Ratio: 0.79 (3.95L EMI/5L income)
What does it mean?
Compared to their monthly income, jack is buying a home which is 47% of his monthly take home income.
John is buying a home which is 79% of his monthly take home income.
So who is overspending? It is John who is overspending.
Rule of Thumb (ROT#1.2): Plan a home purchase such that the the EMI is not more than 0.3 times the take home salary.
# Rule-2. First build your emergency fund.
Do you know what is the best plan for home purchase?
A plan which gives 100% ownership of your home by the time you are 35 years of age.
Yes, by the time you are 35, all home loan gets paid-off, and you have its full ownership.
So what does it mean, should you go ahead and buy your home as soon as you receive your fist paycheck?
No, not so quick.
There is no doubt that home purchase and its full ownership should be a priority of life.
But it cannot be done at all costs.
To plan a home purchase, the first step should start with “looking away” from your home.
Build your emergency fund first.
Once you have a sufficiently big emergency fund in place, go to step two.
How big should be the emergency fund?
It must be at least 6 times ones essential monthly expenses.
What are essential monthly expenses?
Those expenses without which one cannot survive.
Rule of Thumb (ROT#2): Ones essential monthly expenses will be close to 55% of the total expense.
If total expense is Rs.100,000/month, essential expenses will be Rs.55,000/month.
In this case, emergency fund must be Rs.3,30,000 (6 times Rs.55,000).
# Rule-3. Contribute sufficiently for Retirement & Child Plans.
After you have a suffciently big emergency fund, you are still notready to buy a home.
There are two other priorities of life, which are as cost intensive as home purchase.
But are perhaps more important than a home.
Hence one must start contributing here first, before committing to the expenses related to home purchase.
[Read: use this personal financial calculator to estimate how much to contribute towards retirement and child plan]
Why it is important to plan like this?
Suppose your monthly income is Rs.100,000/month. Your monthly expenses are Rs.75,000/month.
Means, your saving is Rs.25,000/month.
Suppose the above calculator told you that, you must contribute Rs.24,000/month towards retirement and child plan.
It means, your savings (Rs.25,000) are just sufficient to take care of retirement and child plan (Rs.24,000).
Hence you will not be able to consider home purchase.
In this case what one can do?
Either one must wait for the pay-hike, or can reduce ones expenses to generate more savings.
# Rule-4. Build your home downpayment corpus – 30%.
This is where the real planning for a home purchase starts.
Before one buys a home, there are few rules that must be set before hand:
- 30% – should be the minimum downpayment.
- 70% – should be the home loan component.
- 15 Years – should be the home loan tenure.
- 3.2 years – time you have in hand to build downpayment corpus.
The above three values, 30% downpayment, 15 years loan tenure, and 3.2 years accumulation time has a specific purpose.
They all contribute to reach a specific objective.
What is that objective?
See, in order to build the corpus for downpayment, you must save and invest money. Suppose this amount is Rs.X/month
After the corpus is built, you are ready to take home loan and buy your home.
Here your home loan EMI should not be more than Rs.X/month
The objective is: Downpayment savings = Home Loan EMI
Yes, if we use the metrics of 30%/15/3.2 , our forthcoming EMI will be same as the savings we are doing now to build the downpayment corpus.
Why it is important to have it this way?
In the corpus building phase, one gets into the habit of saving Rs.X/month. This amount, the person saves every month for 3.2 years.
It almost becomes his/her habit.
If the forthcoming years, when EMI starts, which is also Rs.X/month, the person will not feel its pinch.
He already has developed a habit of keeping aside Rs.X/month.
#4.1 Example: Downpayment and EMI calculation
Just note the below 10 steps.
It will show you how “EMI and downpayment savings” has been calculated.
You must note that: Home Loan EMI = downpayment savings
- Take home salary: Rs.100,000/month
- Max EMI affordability: Rs.30,000/month (calculated using ROT#1.2).
- Home loan tenure: 15 years (assumed).
- Loan interest: 8.5% (assumed).
- Home Loan Amount: Rs.30Lakhs. (calculated using this calculator).
- Value of Home: Rs.43Lakhs (calculated assuming loan is 70% of value of home).
- Downpayment: Rs.13Lakhs (calculated assuming it 30% of value of home).
- Downpayment accumulation time: 3.2 years. (assumed)
- Return of Recurring Deposit (RD): 7.5% per annum for 3.2 years (assumed).
- Monthly Savings in RD for downpayment: Rs.30,000/month (use this SIP Return calculator)
Conclusion
One must plan a home purchase very meticulously.
Random purchase of home will not improve ones financial position.
Instead, there is a high chance of person succumbing under the debt burden.
The best strategy to buy your dream home is to plan it to perfection:
- Estimate the value of house you can afford.
- Build your emergency fund.
- Contribute sufficiently to retirement and child plans.
- Build your home downpayment corpus.
Have a happy investing.
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