How much home loan can I get? (Part II)

In the Part I of this post, I had described a seemingly well set couple; Gaurav and Sneha, planning to buy their first home.  They had taken all the right steps in budgeting their home loan eligibility and are ready to take the plunge into home ownership.  Their financial planner approves of this step, and has given them the go ahead.  However from an early retirement aspirants perspective, they are making a huge mistake, that will potentially ruin any chances they might have of exiting the financial rat race early.  Where did they go wrong?  Isn't owning your own house a good financial milestone?

For starters let us look at some "role models" to see how they spend their money.  To help with this discussion, I will pick people that you have most likely heard of (unless you live in a cave) Let's start with William Henry Gates III, or Bill Gates to you and me.  He lives in Medina, Washington in a home that is approximately valued at US$150M.  In the 2011 Forbes Wealth rankings, Bill is estimated to be worth US$56Billion.  Next, we will profile his close friend and legendary investor, Warren Buffett.  Warren lives in Omaha in his 50+ years old home, that is probably valued at US$1M.  Warren's networth is estimated to be US$50Billion.  Picking an Indian name next, let's talk about Lakshmi Mittal, the steel magnate and CEO of ArcelorMittal who is known for his ostentatious displays of wealth.  Worth a whopping US$31Billion, Lakshmi owns three prime properties on the "Billionaire's Row" at Kensington Palace Gardens that are collectively worth US$1.2Billion.  Speaking of ostentatious, closer to home, we have our own Mukesh Ambani estimated to be worth US$27Billion.  He has just finished construction on his dream home in Mumbai called Antilia, which is considered the worlds most expensive single family home in history costing an estimated US$1Billion.  So what is the common thread in all of these numbers?  Clearly all of these folks (with the exception of Mr Buffett) like to live large and have the money to be able to afford it.  However, even in the most extreme case in the above examples, the amount of money "invested" in the primary residence is not more than 4% of their overall networth.  These business leaders with their enormous spending ability, choose to spend an extreme of 4% (and on average less than 1%) of their networth on their primary residence.

Now lets contrast that with Gaurav and Sneha.  They are just starting off on their careers, and by no means do they consider themselves rich and wealthy.  In fact they are firmly entrenched in the category of the new middle class in India.  However, with their goal to purchase a flat worth Rs52 lakhs, their networth would have to be Rs 13Cr, if they want to match up to the 4% primary residence spending guideline from above!  Clearly, by this metric they are spending much more than their means, on this new flat purchase.  Now I have picked the extreme examples from above, to really up the contrast on spending strategies.  In reality, given the extremely high networths of the individuals I have considered it is not surprising that only a very small portion of it is spent on their primary residence.  However, it does illustrate the point that many times we over-estimate our spending capacity based on our ability to maintain the cash flows required to fund the expense. 

Like I described in my earlier post on Compound Interest 101, the initial years when saving/investing for a financial goal are crucial in terms of corpus growth.  In the early days of Gaurav's career, his networth will primarily grow based on the quantum of his savings.  Only after his corpus has reached a significant amount, will the power of compounding take over and continue to power future corpus growth.  In this crucial early period of his career, when Gaurav should be saving and in turn investing aggressively, he is choosing to block up as much as 50% of his net take home income (not to mention the 15% down payment on the home) in his primary residence.  Now the primary residence can be considered an asset as well (most financial planners do that) since it does have value, and is not a depreciating asset.  However, since it is your primary residence it will not bring in any income on its own.  The value of this asset might increase, but this is only a notional or paper growth in assets, since there is no way for you to monetize this asset, unless you sell your house (but then where will you live?)  Reverse mortgages are slowly finding popularity in India, but this is a step that you will only take once you are deep into your retirement years. 

In summary, though Gaurav is eligible to take on this level of financial commitment, once he signs the home loan papers, he might as well kiss any hopes of early retirement goodbye.  Once the home loan documents are signed, he has tethered himself to the bank, and for the foreseeable future (25 years is his home loan tenure) will work 33% for the govt (assuming he is in the 30% income tax bracket), another 33% for the bank (since he will be paying off 50% of his take home, or 33% of his gross income, towards EMIs) and only the final 33% for himself.  In effect for every 3 days of work that Gaurav puts in (and I am sure he works in a high stress environment to be able to command such a high salary) he only gets paid for 1 day (since the remaining 2 days worth of income is taken by the govt and the bank respectively)  Gaurav will have to continue slogging away at work, and the situation will most likely get tougher for him, if his wife Sneha were to choose to stop working (since her income is also accounted for in the home loan eligibility computation)

For early retirement aspirants, the conventional thought of paying around 45%-50% of your take home income for home loan EMIs is a non-starter.  I am not suggesting that you should not buy a home.  Just realize that your primary residence, is a paper asset that does not bring in any monthly income, and though it appreciates in value, the gains are only notional.  I would recommend a much more conservative 15-20% of your net take home salary to pay for any home purchase, leaving plenty of monthly income in hand for aggressive savings and investments.  Particularly for folks early in their careers, aggressive savings is critical to unlock the power of long term compounding of wealth.  Dial down your first home purchase aspirations and give yourself a shot at quick financial freedom and early retirement.  Else follow conventional guidance, buy the best home your money can buy, and commit yourself to decades of daily grind in pursuit of financial freedom. 

How much home loan can I get? (Part I)

Buying a home in India, or for that matter anywhere in the world, is a big decision for most people.  It is most likely the single biggest purchase you will ever make in your lifetime.  Gone are the days when one used to save for a lifetime, before finally being able to afford a small home towards the end of your career.  Today India is growing by leaps and bounds, and the average home buying age in India is dropping every year.  The Associated Chambers of Commerce and Industry of India (ASSOCHAM) estimates that the average age for home buyers in the 1980s was 55-58 years in India.  In stark contrast, since 2000, the average age for first time home buyers for personal use has dropped to 30-38.  Many first time buyers are either just married, or many times choose to buy a home even before marriage.

In most Tier1 cities in India, the trend I see these days is that once a person graduates from college and begins working, the first big ticket purchase they consider is a car, and the second one is a house.  In most Indian families, even after the children start working they typically continue to live with their parents and siblings.  After a few years of working when they are 25-28 years of age for boys, and a couple of years younger for girls, the thoughts turn towards owning a home.  Guys typically prefer to buy a smaller new home (maybe a 1BHK) just prior to getting married, so they can move in as soon as the wedding is done.  The other alternative is to buy a bigger new house (upto a 3BHK) so the newly weds can have their privacy, while still living with their parents.  Girls on the other hand might typically wait to get married, and then right away begin the search for a home, since the joint income of the husband-wife couple is more than enough to afford a good home.  Many times the quality and size of home you currently live in, or plan to buy soon, can be a critical factor in influencing the choice of life partner, with families preferring to create marriage alliances with their social and financial equals (as measured by the size and quality of their dwelling!) 

Buying a home in India can also be a very emotional decision, heavily influenced by family, friends, peers and the unique social environment we live in.  Peer pressure plays a big role here as you see your friends and colleagues purchasing homes.  There is also a desire to show that you have "arrived" and the best way to do so, is buy purchasing the biggest house you can afford.  A nice upscale colony, with a fancy clubhouse, tennis courts, gymnasium, walking/jogging track etc helps in setting the bragging rights, even though you may have to pay a stiff monthly maintenance fee for several of these amenities that you probably never use!

Of course we always rationalize to ourselves that surely we deserve the best house we can afford.  We want to provide the best living conditions for our parents given that they have sacrificed so much for use.  We want our kids to have the best amenities, and access to swimming pools, tennis courts, basket-ball courts, play areas, etc, since we did not have that luxury when we were growing up.  The list of reasons is endless, and I am not debating right or wrong.  I had the same thoughts while we were trying to figure out where to buy a home ourselves.

Let us take the example of 29 year old Gaurav who is married for a couple of years now to Sneha and is soon planning to have kids and start a family.  This is of course a fictitious example, but helps to illustrate my point better.  Before Gaurav and Sneha decide to have a child, they would like to purchase their first home.  They would like to go for a 3BHK, since 3 bedrooms would give the family enough space and privacy once they have a child.  Since both Gaurav and Sneha are salaried employees, they expect one set of parents (either Gaurav's or Sneha's) to stay with them almost throughout the year, to help with taking care of their child.  A good apartment complex near the upcoming outer peripheral road would be a good place to invest in a home, since there are several new developments happening in that area.  Good schools are expected to come up there soon, and both their offices are also within a 10Km radius.  The first thing Gaurav does is search online for how much home loan can he get given their combined joint monthly income.  Gaurav and Sneha are very disciplined and do not spend extravagantly.  They do not have any personal loans or student loans and pay off their credit card bills promptly.   Their joint monthly take home income is Rs 80,000.  Gaurav and Sneha approach a leading bank to negotiate a pre-approved home loan so they can decide on the budget for their dream home purchase.  The bank informs them that they typically sanction a maximum EMI of 45-50% of the net take home salary, and encourages them to jointly apply for the home loan to maximize the total loan amount.  Also since they dont have any other personal loans, or credit card debt, and their credit rating is impeccable, the bank agrees to extend the eligible monthly EMI to 55% of their take home pay.  This means the bank estimates that Gaurav and his wife can comfortably pay a monthly EMI of Rs 44,000.  After all the bank manager also has home loan disbursement targets to meet, and a young couple with a strong employment history is an ideal customer for the bank. 

Gaurav decides to maximize the tenure of the loan to further bump up his overall loan eligibility.  The maximum term with this bank is for 25 years.  The home loan interest is a floating rate of 10% per annum.  Based on these parameters, Gaurav is eligible for a home loan of Rs 44 Lakhs (I used the home loan EMI calculator available here at ApnaPaisa) Since the bank will only fund upto 85% of his loan, his maximum budget can be Rs 52 Lakhs with the 15% margin money of Rs 8 Lakhs being Gaurav's responsibility.  Gaurav and Sneha are overjoyed by this and sign up for the pre-approved home loan.  They can now buy a flat of their choice upto a maximum budget of Rs 52 Lakhs.  This is a fairly conventional storyline, and is repeated hundreds of times across various banks in India. 

So what is wrong with this story?  Well nothing much, if you are counting on a conventional financial plan, with traditional milestones of marriage, family, owning a home, working hard till the age of 60-65, and finally leading a happy retired life.  But this does not work for early retirement aspirants.  In my next post we will dissect this case study from an early retiree's perspective, and see why this plan cannot co-exist with thoughts of early retirement. 

Inflation in India

Inflation is a much maligned but sometimes poorly understood phenomenon that has the most significant impact on any personal finance plan.  Particularly in a emerging country like India, inflation can be so rampant as to be the fundamental parameter that influences all investing decisions.  Inflation is usually defined as a rise in the general level of prices of goods and services in an economy over a period of time.  In the words of noted economist Sam Ewing, it is the reason why you pay $15 for the $10 haircut that you used to get for $5 when you had hair. 

First it would be instructive to look at inflation in a mature developed economy like for example the US.  In recent years the US has not experienced significant inflation levels, with the inflation rate hovering around 3-4% for the last decade.  The following is a chart from Wikipedia that shows the US CPI Inflation over the last century.

Over the last couple of decades since 1990 US inflation rates have been relatively stable and low.  Inflation rates of around 3-4% seem very comfortable and makes financial planning over the long range, a tad bit easier.  The interesting thing is that in the 70s inflation was very high averaging in the high single digits, and peaking at 15%.  My key takeaways from this graph are that even in a mature economy inflation if not controlled can go up significantly, and also the variability in the inflation rate cannot be avoided particularly over timeframes that range over decades (like hopefully my retirement days)

Now lets contrast this against the inflation rates seen in India.  I found this historical annual CPI inflation data on the Worldwide Inflation page.

As you can see inflation in India since the mid-70s has averaged around the 10% mark.  The 1999-2005 period in recent memory is almost like a "Golden" period from an inflation perspective, characterized by low levels of inflation, and possibly the resultant bull market.  However, the recent high inflation rates that many of us are complaining about, is just a return to the mean that our parents struggled with through the entire earning careers.  The early-70s seem an aberration due to the events of the time like the India-Pakistan wars, and more importantly the oil-shock of 1973-74.  Before that the mean seems to hover around the 10% mark.  There is not much point looking at inflation data prior to the 50s since the conditions in pre-independence colonial India were very different and lessons learnt from that period are most likely not applicable today.  My key takeaway here is that the India has always worked with a high inflation rate of 10% and I don't see the norm changing in the near future.  Periods of low inflation (in the low single digits) are few and rare, and should be taken advantage of, as and when they occur.  In the meantime, we should be looking back to the age-old methods used by our parents to combat high inflation rates.

Here are some, at first glance non-intuitive, but extremely sane financial decisions that I have seen people make as a result of the prevailing high inflation environment.

We tend to stock up on non-perishables as we know the same product is going to cost more next month.  In these times of rising incomes, people have more purchasing power, and I routinely see them buying large quantities of soaps, cosmetics, house-hold cleaning agents, even grains, biscuits, basically anything that is non-perishable and can be stored for a month or longer.  Every super-market you walk into, you can see sales on bulk non-perishable goods, and people willing to buy these bulk products (for example a pack of 5 soaps, that will probably last a family of 4 for 3-4months) knowing fully well that the same item will cost 5% more in a few months.

Real estate has seen a crazy spiral of inflation driven price increases.  There is a mad rush to acquire property due to the fear that the same house or plot of land will appreciate between 15-20% in a year, pushing it out of your spending capacity.  Builders and property development firms take advantage of this phenomenon by launching huge developments with 100s and nowadays 1000s of flats, with the firm belief that they will be able to find customers to lap up these offerings.  The average joe is in a rush to buy property to "lock-in" today's price, since he/she knows that in as little as 5-7years the same property will cost double the price.

Wages are caught up in an inflation driven spiral as well (economists call this cost-push inflation) as employees clamor for higher wages in order to maintain their lifestyles in a high inflationary environment.  This in turn drives up costs further, and adds to the cycle of inflation.  The new Gen-X and Gen-Y employees have become used to this environment and typically expect wage increases in the double-digit percentages.  This expectation (which has been met in recent years) leads to unhealthy financial decisions that are dependent on future expected wage hikes.  The younger generation is willing to make bigger purchases, most times leveraging on loans, expecting to be able to repay them with future wage increases. 

It makes financial sense in a high inflation environment to accumulate (or hoard) products and assets.  In addition to hoarding what you can afford with your current wealth, most folks begin to leverage by taking loans to accumulate assets beyond their current means.  The thought is that the high inflation environment will continue, and future loan re-payment will be with a de-valued currency that is progressively easier on the borrower. 

Health care costs continue to spiral, making it difficult to estimate insurance premiums and how much insurance cover to purchase.  Insurance firms increase annual health care premiums, and keep releasing products with higher insurance limits, and more innovative schemes like top-up insurance products with high deductibles.  There is also a brisk trade in life insurance policies since the term insurance that you bought 5 years ago for Rs 10 lakhs cover, no longer seems adequate today simply because of the de-valuation of currency due to inflation.

Finally, retirement plans are most impacted, since any form of fixed retirement income (PPF, NSC, FDs etc) is typically not inflation indexed and hence doomed to failure.  Equity and real estate are probably the only forms of inflation indexed investments that can combat the high prevailing inflation rates.  And predicting a retirement corpus to enable early retirement becomes a herculean task to estimate with any reasonable degree of accuracy.  

The positives in this story are that, high inflation environments have existed before in mature economies, and are fairly typical in other emerging economies even today.  We should be looking for strategies for wealth management and growth that have worked in these environments in other countries, and adapt and apply them within the Indian context today.  This would be the right approach since, "The middle class learn from their own mistakes, while the rich learn from others mistakes!"

Generational Finance NOT Personal Finance

Just do a google search for Personal Finance, and you will see tons of websites, blogs, articles, marketing pitches etc, all doling out advice on personal finance and how to go about achieving the various goals, investment decisions, savings rates etc associated with it.  It is amazing how much information and guidance gets dished out and consumed relating to this topic.  I guess, Personal Finance gets down to the core of who we are, what we do, and how we do it, and touches every aspect of our lives, which is why it is so hotly discussed, debated, talked about, and basically flogged to death on every financial TV channel, news media, or personal finance blog that you come across.

Now typically, when it comes to the savings and investments part of personal finance, every single financial planner and wealth management guru seems to approach it in the same structured manner.  The first step is to collect data about the person (or nuclear family) in terms of his/her current financial situation.  This could be in the form of  assets, liabilities, income sources, expenses, investments, insurance, etc.  The next step is to document all the financial goals, and try to assign a timeline and a Rupee (or Dollar) amount to it.  Then, typically the financial Yoda (Star Wars reference) will pull out a bunch of assumptions based on historical data and future projections, regarding risk and returns for different asset classes, and suggest a quantum of money for savings/investments and the asset class mix, to attain each separate financial goal.  This overall summary is called the Personal Finance Plan, that is handed out to the client with a hefty charge for the service.  I have seen this pattern repeated over and over ad nauseam, with only minor variations in the overall storyline. 

Pictorially you could think of a Personal Finance Life Cycle to look like this. 

The actual age at which you target these goals, or even the goals themselves may vary from person to person, but the concept is basically the same.  For each financial goal, the planner will suggest a quantum of investment and an asset strategy that starts with an aggressive allocation plan, and then subsequently moves to safer and lower risk allocations as the goal gets nearer and nearer.  This is the time honored method of PERSONAL financial planning.

I propose that this method has become dated and a new thought process is required to redefine financial planning.  The key change in thinking is to plan in terms of GENERATIONAL finance, and not PERSONAL finance.  Lets do a thought experiment for a minute wherein the same financial planner as before, is providing financial advice to the person above, and at the same time also to his father and son.  To explain simply, lets assume that the planner is providing financial guidance to 3 generations of the family across their entire lifetimes, all in a synchronized manner, rather than looking at each persons financial plan in isolation.  In this new scenario the planner will observe that major financial goals will typically come up in every 5year cycle (either for the grandfather, father or son; forgive the patriarchal assumption here, but I need to work with something and a matriarchal lineage would work just as well for this thought experiment) Basically every 5year cycle or thereabouts, major financial goals will mature, need to be funded and retired.  So I hypothesize that a simple asset allocation of 90% aggressive investments (high return, high risk; be it equity, real estate, or whatever if the flavor of the day) and 10% safe investments (low return, low risk; be it CDs, FDs, debt or whatever works at that time) should be sufficient for the GENERATIONAL planner to meet all the Generational goals.  At any point in time, there will be 1 goal that will be nearing maturity, and which will need funding, and all other goals will be at a longer timeline. 

Fundamentally, I do not believe this is a new concept at all.  In India, all large corporations (except the more recent ones) have been built up over generations and are tightly owned by a single family (Tata's, Birla's, Ambani's, Wipro, Mallya's, etc).  This is also true, maybe to a smaller extent in the US (Walton's, Hilton's etc) Typically multiple generations of the family are involved in building up and maintaining the scale and size of the corporation and in turn the family wealth.  Even in historical times, kingdoms were ruled by dynasties that held power for multiple generations (Mughals, Guptas, Mauryas, Peshwas etc).  For that matter even today the Indian political system is dominated by one family, and I could argue the same for the US a few decades earlier (the Kennedy's)  Taking a holistic view of generational wealth building, can help you develop plans that are better suited and optimized to help you meet all your generational goals and not just your personal financial goals.  Also the longer timelines associated with generational wealth building, can significantly increase the power of compounding, and mitigate the probability of high risk asset strategies failing on you. 

And the amazing part is that there are live running examples of this concept that you can look at right now!  Trusts are fundamentally formal structures that enable generational wealth management.  Trusts are able to look at long term trends and benefit from a longer timeline that allows them to make the right investment calls.  For example the Harvard Management Company (HMC) maintains and manages the Harvard University Endowment Trust.  The trust forms the backbone of the university funding, and all new grants and withdrawals are managed around the core endowment fund.  You can think of your generational wealth also in similar terms, with core assets that keep growing form generation to generation, and your own personal income and withdrawal needs to be managed around the generational core.  In fact in India we have the concept of HUF (Hindu Undivided Family) which is a legal financial entity, that can own and invest in assets, is a taxable entity and can be managed separately from your own personal financial entity, even while you are a partner in the HUF. 

So in summary, I posit that taking a holistic view at Generational Finance is the secret of all the large wealth (or power) building efforts that you see in history, which take advantage of the compounding effects of decade and even centuries in generations rather than just years within a single generation.  I also propose that there are already legal avenues like Trusts and HUFs where you can see this in action today.  All you need is a paradigm shift in thinking from Personal Finance to Generational Finance, to open up new methods and avenues of investment thoughts and actions. 

Let me know if you agree with my thought process on this.

India Early Retirement and Formula F1 Racing

Formula F1 Racing debuts in India for the very first time today, at the 875 acre Buddh International Circuit.  The high octane world of car racing is as alien to me as bob-sledding is to Jamaicans (obscure reference to the movie Cool Runnings)  It takes some patience and extreme passion to enjoy watching several futuristic looking cars, that all look pretty much the same to me, hurtling around an odd shaped track of 5.14Km (about 2.34Miles) over 60 times.  The fastest drivers can complete one circuit in as little as 1.5mins, setting an average speed of over 200Kmph.  Still there is a lot of interest in this fast growing sport in India, and we expect the popularity of car racing to grow exponentially in coming years.

So why are we talking about Formula F1 Racing on a early retirement blog? Well that's because I believe there is an enormous similarity between  F1 racing and Early Retirement, that is just too glaring to ignore.  Stumped? Well you wont be, once you have read through the remainder of this article. 

Even though F1 racing has this reputation of being an exotic sport, which attracts the attention of only a very small percentage of sports fans, there is one critical function that it performs in the world of automobiles.  Formula F1 Racing is relentlessly pushing the envelope on what is possible in the world of automobiles and transportation.  Both technology and human endurance are pushed to the limits in this sport.  But the naive reader may ask, What does that have to do with me? The answer is simple, and it has everything to do with you as long as you own a car, or use any form of automobile based transport.  Formula F1 has been for years pioneering cutting edge advancements in technology that eventually filter their way down into stock road cars that you and I can buy out of a showroom or dealership.  Advancements in engine technology (horsepower, lighter engine blocks, turbo, internal engine coatings etc), brakes (Anti-lock Brake Systems or ABS, disc brakes, carbon composite brakes etc) fuel injection systems, car body and chassis (streamlined carbon fibres, exotic composites, safety glass etc) and virtually every component of car design, have been pioneered on F1 cars, before making their way into productized road cars.  This has helped improve the safety, reliability, comfort, and cost of the road worthy car models that you and I can buy off the dealership.  This is one of the key reasons that several car manufacturers and car component manufacturers, own or sponsor F1 racing teams, since it gives them an excellent platform to showcase their latest technology and also test it under extreme conditions before implementing it on the thousands of cars that they manufacture and sell. 

Now here comes the punchline:  I propose that early retirement enthusiasts, such as yours truly, are the F1 cars of the retirement and personal finance industry.  We are the ones that come up with the exotic plans, asset allocation strategies, frugal living methods, safe withdrawal rate computations, risk-reward analyses, long range retirement planning, innovative use of financial products, early adopters of new products, market influencers to develop new products, you name it, that relentlessly pushes the envelope on personal finance and retirement planning.  As the myriad of wealth management firms, banks, insurance companies, Asset management organizations, Financial Planners, etc continue to come up with advancements, methods and strategies, we are the ones who are most likely testing them out in the real world, in our extreme early retirement scenarios, to make sure that they are "road-worthy" for the average traditional personal finance and retirement aspirant.  The purpose of this blog is to share the results of this "F1 road testing" of my personal retirement plan with you, so you can incorporate pre-tested, sure-shot, aspects that are relevant to you, in your financial planning.

By the way it looks like Sebastian Vettel of team RedBull is the winner of the inaugural Indian F1 Grand Prix.  I hope to emulate him in the world of personal finance and retirement.