Wednesday, 9 November 2011

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. 

1 comment:

  1. Thank you for sharing such great information. It has help me in finding out more detail about Housing Loan!