Budgeting for your house

In this second post on a series on buying a house, I look at deciding the budget for a house. I assume here that the house is being bought for personal usage and not for investment. I look at a number of rules of thumb and show how they result in similar values.

Thumb Rules

1. The value of the house should not exceed 3-5x of your annual post tax income.
2. The EMI should not exceed 40% of your monthly post tax income.
3. After EMIs and expenses you should be able to save 15-25% of your post tax income.
4. The EMI should be twice the rent.
5. You should be able to make the down payment with 2-3 years of savings.

Justification

Much of the justification for the above come from models of expenses. For a family earning 1,00,000 Rs monthly after tax, the following seem reasonable.

• 30% (Rs 30,000) in monthly living expenses. This includes expenses on food / groceries, fuel, utilities, clothes, health, education, entertainment and other expenses.
• 30% (Rs 30,000) in rent and depreciation of major capital items like furniture, appliances and car. Of this, roughly two-thirds (Rs 20,000) will go for rent, one-sixth (Rs 5,000) will go as depreciation for car and remaining (Rs 5,000) will go as depreciation for appliances and furniture. The depreciation would roughly be the case if you have a car worth 3-4 Lakhs and total value of furniture and appliances worth roughly the same.
• 20% (Rs 20,000) savings for major financial goals other than retirement.
• 20% (Rs 20,000) savings for retirement. Half of this will usually come from mandatory savings (EPF etc) and the remaining half should be invested in equity via mutual funds etc.

 The ratios usually hold out over significant income range (say 25,000 per month to 4 lakh per month).

From the above we see that the rent is 20% of income so rules 2 and 4 become the same. Similarly after deducting the EMI of 40% of monthly income, the family would still be able to save 20% so rule 2 and 3 also become the same. 

Lastly, at current interest rates (10%), a 25 year EMI comes to around 1% of the house value. So if the house is 3.3 times your annual pay, the EMI will be (3.3*12*0.01) 40% of your monthly pay. Similarly, if the interest rates are 6% and the house is 5 times the annual pay, the EMI again will be 40% your monthly pay. So rules 1 and 2 again become the same.

Lastly, if you use all your savings (25-30%), in 2-3 years you will have around 75% of your annual pay which will be sufficient for 20% of a house that costs 3.5 times your annual pay. So rules 5 and 2 also become the same.

Together, these imply that with a monthly income of Rs 1 Lakh, you can buy a house worth 40 Lakhs.

But this is too low

This would be your first reaction, especially if you are actually living in a house with a rental of 20,000. Generally, such houses would sell for around Rs 1 crore. Please note the following caveats which shows that the above is not really an underestimate - 

1. We have not considered property taxes and maintenance expenditure on the house.
2. The above assumes that you are buying a ready to move in house. If it is still under construction, the EMI that you can afford goes down - almost by half.
3. The above also assumes that all the money for your other financial goals will come only from increase in income. So do not assume future increments for a higher value of the house that you can afford.

So the end result is that you really cannot actually afford a more expensive house.

Options

 You are then left with the following options

1. Buy a smaller house or in a less desirable location and downgrade your lifestyle.
2. Save more money from expenses and retirement savings to fund a larger house.
3. Buy a house or land in another city as an "investment".
4. Continue living on rent.
5. Unconventional ways to significantly reducing expenses (living with your parents, delaying / not having kids, extremely frugal living)

 Of course, none of these options are easy. You need to ask your why you want to own a house to really decide between them.

For people who have not yet married or are just married, my recommendation would be a combination of 4 and 5. Frugal living on rent will allow you to save a good amount of money; 70% of your after tax income is actually doable. 4-5 years of savings of that nature can easily result in a situation where you have saved 3-4 times of annual income. Such a corpus could open up a large number of opportunities.