How much Housing Loan should you take?

Most people need a housing loan to purchase their first house. And I know what you might be thinking when you saw the title of the post ‘how much home loan should you take’.

As much as possible or as much as I can afford. Isn’t it?

But before we talk about in detail as to how much home loan should you take, let’s give some thought to the on-going but growing debate between buying vs renting a house.

I will try not to take sides but it is difficult.

A house in spite of being the biggest expense of most people’s lives is also an emotional decision. And no number can be attached to this emotion. No matter what the online buy vs rent calculators might be telling, I believe that most people would want to buy a house eventually. That’s what makes us human. 🙂 Ofcourse there will be some who feel that staying on rent forever is the way to go. But such people are still in a minority.

Now I am not a very big fan of real estate as an investment. I prefer equity. But I also feel that having one house somewhere is a good idea. Whether you decide to buy a house early in your career or later is a personal decision. Since I mentioned the word ‘investment’, here is a detailed analysis of investing in Equity Mutual Funds vs investing in Real Estate. You might find it interesting. You can also have a look at this Real-Life case study of MF vs Real Estate investing in India.

So let’s come back to the agenda for this post

How Much Housing Loan Can You Take?

This is not an easy question for most people but it also has a mathematical approach to help you decide.

Let’s look at it from the lender’s perspective. What does a bank/organization giving home loan wants to know?

• Do you earn enough to be able to service the home loan EMIs?
• Will you continue to earn enough to repay the home loan fully in future?
• How has your past loan repayment behaviour been? Did you miss paying EMIs occasionally or regularly?
• Do you have other loans (like a car loan, personal loan, education loan, etc.) where you are already servicing the EMIs?
• Do you have some other financial assets as well?
• Can you bring in some money (about 20% downpayment) from your own pocket to make the house purchase?

These are some of the major factors that lenders consider among many others.

Now generally, lenders have this rule that says that you should only be using about 30-40% of your income for loan repayments. Let us assume 40% for simplicity.

So if you earn Rs 1 lac per month, lenders will give you a loan that has a maximum EMI of about Rs 40,000 (i.e. 40% of Rs 1 lac).

If now you do some reverse calculations, you will know what home loan amounts are available for the EMI of Rs 40,000 per month. Ofcourse the loan amounts will vary for different combinations of loan tenures and interest rates.

So from the lenders perspective, we have answered the question – What percentage of monthly income should my home loan EMI be?

But let’s be practical, I am pretty sure that most people would be willing to stretch this ‘40% of monthly income as EMI’ to even ‘50% or even more of monthly income as EMI’ if the right property comes along. Isn’t it?

But should you do this?

Because this will obviously impact your ability to manage your personal finances, savings for other financial goals and your lifestyle. And everybody has a different expense pattern so it is difficult to say anything in general. So some people will find it comfortable even if they have to pay more than 50% of their income as EMI. Others will find it difficult to pay even 30% of their income as EMI due to higher expenses.

Also, what if you are taking a loan with your spouse and eventually the plan is for your spouse to quit working? Will you still be able to foot the entire EMI bill from single income?

Some feel that renting for some more years is better than choosing a small house just to keep your loan EMIs down. Then there are others who feel that it’s better to buy a house (even if small) soon and then, later on, when income is higher, they can buy a bigger house by selling the first one.

Both seem to be practical approaches. To be honest, it’s difficult to judge anyone here.

Buying a house as soon as possible gives you the satisfaction of having arrived in life. You own a house dammit! 🙂 You are also protected from the future increase in property prices as you have already made your purchase. You can then use fresh enthusiasm and free surplus income to pursue other financial goals (free excel download).

Buying a house later when you are more settled and have a higher income is also one common approach. Since income is high, you can even go for a bigger and better house (assuming you need it) as you can service a bigger loan and EMIs as your EMI/Income Ratio (40% max) has a bigger denominator.

As I said earlier, both approaches are right for different types of people. It’s a personal choice.

You already know that your credit history plays a major role in the lenders deciding whether to lend to you or not. Your cibil report tells the lender how you have been repaying your past loans. Have you been a good borrower who repays each EMI on time? Or you have been a not-so-good borrower who misses his EMI every now and then and finds it difficult to close his loans cleanly.

And did you know that in some cases, your score also decides what loan interest rate will be offered to you? If your score is high, you might get the loan at a lower rate! And that can save you tons of money in the long run. So it would be a good idea to check your credit score before you apply for a home loan. Atleast you will know whether the score is good or bad and accordingly, you can negotiate with your lender for better loan rates.

Note – If you are yet to buy a house using a loan, don’t go overboard if home loan rates are falling and property prices are down. Always assess your individual financial situation whether to go for a loan-funded property purchase or not.

Some More Thoughts

Real estate juggernaut went on for more than a decade till it eventually slowed down in last few years. Earlier, people used to keep taking loans to buy houses and sold them a few years down the line because prices were rising enough to prepay the home loan and still make a huge profit. And this was being repeated. An entire ecosystem got built around people’s interest in this asset as an investment (Read more about the reality of Indian real estate).

But people still need houses and will buy them. If not as an investment (thankfully) then as something for personal use. I offer some thoughts here about making the house purchase:

• Buying one house is enough for you. And unless you are really getting a good deal in properties, there are other reasonably good investment options to consider.
• If you want to buy a house in the early part of your life, then so be it. But still don’t be in a hurry. It’s a big decision. Take your time to decide it correctly.
• Banks and other lenders want you to take a huge loan so that they can earn interest on higher loan amounts. But it’s in your best interest to not stretch yourself too much. They say 40% of your income can be used for EMI payment. But if you can bring in higher downpayment (i.e. take a smaller home loan), then it is not a bad idea to have a lower EMI component.
• It’s a good idea to wait for a few years and save up a sufficiently large amount (preferably larger than 20% of house cost) as the downpayment. Depending on your saving capability, eagerness to buy, available time (years) at hand and market conditions, you can even consider having some equity component in your savings for this downpayment.
• Understand this concept fully – shorter the loan duration, lower will be the interest component, but higher will be loan EMIs.
• Depending on how much home loan EMI you can comfortably service with your current income, keep the loan tenure as about 15 or 20 years.
• Do make up your mind that you will clear this loan earlier than the originally stipulated tenure. But making mind is not enough. You will have to do something about it too.
• One way is to try and pay one extra EMI every year (atleast).
• Another way is to use your annual bonuses to prepay part of the loan.
• Then there is a case for going for a longer than usual loan tenure of let’s say 30 years. Why and when? This approach uses a combination of home loan EMI and mutual fund SIP. A longer tenure means lower EMIs. The savings made on lower EMIs can then be invested every month in something like equity mutual funds SIP– which is expected to do well over long periods. Assuming equity does deliver decent returns, this approach of selecting a longer loan tenure and doing the SIP can help you repay your loan earlier. This approach might suit some people but is not for everyone. I will write about this approach in detail sometime later.
• There are many who want to do keep it simple and be done with their loans as soon as possible (and live a loan free life) without any financial jugglery. They will aggressively repay their home loans. But if done too aggressively, this approach can compromise savings for other financial goals. And that is not advisable – more so because home loan rates are fairly low if you consider tax breaks on offer.
• Ensure that you have an adequate life insurance that can be used to pay off the loan if you were to die tomorrow.