Categories: General

Personal Finance Rule 7 – Buy a house only when financially ready

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Buying a home is one of the biggest decisions that an individual makes. In the present context, it is usually an emotional decision to buy a house. This short article looks at the financial factors to be considered before this big decision. This article is a companion post to the India version of Harold Pollack’s Index Card – Pollack’s Index Card: All the financial advice that you ever need – India version

Buying a house doesn’t make financial sense – usually

There is an eternal debate about the financial soundness of buying one’s primary residence. There are many opinions, analysis and comparisons that seek to show that renting your house is better than buying. While there are many factors that are involved in this analysis, the most crucial factor is the rental yield. If rents are low, then financially it may be better to rent your home and invest more in financial assets. However, emotions play a huge role in this decision. Due to multiple factors, people want to buy their primary residence and ‘make it a home’. In other words, people buy their primary residence because they are emotionally ready for it. To focus on the main message of this article, we would leave aside why people want to buy their primary residence.

House as ‘Investment’

A lot of financial literature suggests to consider real estate, including your primary residence, as an investment. If you view dispassionately from a financial viewpoint, your home is not really an investment. Yes, you spend a lot of your money on it. Yes, it gives indirect returns by way of saving on rent. Yes it appreciates in value, at least hopefully so. However due to the same emotions being at play, most people can not think of selling their primary residence. Mainly due to this reason, many formal definitions of networth exclude primary residence. Buying a house has impact other investments as it diverts money from other investments.

Being Financially Ready for a house

Most people buy their first house using a home loan. A lot of them make the decision when they get qualified for a home loan. This is just one part of the financial readiness. There are a few more factors that can have an adverse impact on your financial plan. We list some major factors that determine if you are financially ready to buy a house.

Downpayment – You should be able to make the margin payment – usually between 10 to 20% of the value – from your own assets. It does not help at all to take loans for this.
Emergency corpus – It is advisable to keep 6 to 12 months of expenses as an emergency reserve. Once you take a home loan, this should also include the home loan EMI. The emergency corpus needs to be considerably larger.
Registration, Furnishing, etc. – Typically home loans can cover these large expenses too. If not, you should be able to cover them with existing savings.
Life insurance – Largely the home loan provider would insist that you take up additional life insurance equivalent to the value of the loan. Even otherwise, you should significantly increase your life insurance cover since you now have a major liability.
No impact on long term goals – This is a major factor. Home loan EMI should not have major impact on your investments towards long term goals. Yes, some impact is unavoidable since EMIs can be a large part of your income. But EMI should not crowd out all other investments.
Liquidity/Fungibility – This major factor depends more on the house and less on your finances. It is most helpful if you have the ability to exit from the asset, if required. For houses, this would typically mean that you buy a property that is ready for occupation, or is very close to that stage. Pre-launch and under-construction houses may look cheaper; but delays in completion could severely dent your financial plan.