Table of Content:
- Introduction
- What exactly is the 5/20/30/40 rule?
- Benefits of Following the 5/20/30/40 Rule
- The Drawback
- Personalising the Rule
- Conclusion
The 5/20/30/40 Rule: Your Key to a Stress-Free Home Purchase
Crafting a financial plan before buying a home is like designing the blueprint for your dream house—it lays the foundation for a successful journey. With a clear plan, first-time homebuyers can transform the complex process of home buying into a series of manageable steps. Also, having a plan not only maps out the budget but also acts as a financial compass, guiding homebuyers through savings, debt management, and mortgage options.
One effective plan for first-time homebuyers is the 5/20/30/40 rule—a straightforward guideline that helps in confidently managing the financial aspects of buying a home. Let’s explore how it works:
What exactly is the 5/20/30/40 rule?
Suggested by experts, this home-buying rule turns your finances into a strategic plan. Here are some scenarios to help you understand what these numbers mean:
- The 5x Rule:
The “5” in this rule stands for the total cost of your new home. As per experts, the price of your new home should be no more than five times what you earn in a year.
Scenario:
Imagine you earn ₹10,00,000 annually. According to the “5” in this rule, your dream home should cost no more than ₹50,00,000 (which is 5 times your income). This helps ensure that you’re not stretching your budget too thin.
So, if you’re looking to buy a house worth ₹70,00,000, it might be a good idea to adjust your expectations or save a bit more before making a purchase.
- The 20-Year Mortgage:
The “20” refers to the mortgage term, which should ideally be kept to 20 years or less. This way, you’ll pay off the loan faster and become debt-free earlier than usual.
Scenario:
If you take a mortgage to buy a ₹50,00,000 house, aim to repay it within 20 years or less. For instance, if you choose a 15-year term instead of 30 years, you’ll pay off the loan quicker and save a significant amount on interest over time.
Now, a shorter term might result in higher monthly payments, but it could also help you avoid paying more in the long run.
- The 30% EMI:
Next comes the “30”. It connects with your EMI (Equated Monthly Instalment). As per this rule, you should ensure your new home’s EMI does not exceed 30% of your monthly income.
Scenario:
Let’s say your annual income is ₹12,00,000, and your monthly income is ₹1,00,000 (₹12,00,000 divided by 12). According to the “30” rule, your EMI should not exceed ₹30,000, which is 30% of your monthly income.
This rule helps ensure that your mortgage payments are affordable and manageable within your overall budget for the new house.
- The 40% Down Payment:
Finally, we reach the “40” in this rule. This part refers to the suggested down payment for your new home, recommending that you aim to put down at least 40% of the house’s cost. However, it’s important to note that the minimum down payment can vary depending on the lender, the type of loan, and your credit score. Different lenders may have specific requirements, so this 40% figure serves as a general guideline rather than a strict rule.
Scenario:
You have set your sights on a beautiful house priced at ₹50,00,000. To make this dream a reality, you need to save a 40% down payment, which amounts to ₹20,00,000. Saving up this substantial sum may take a while, but the effort is well worth it.
By putting down a larger amount upfront, you’ll reduce the total loan required, leading to smaller EMIs and less interest over the life of the loan. Additionally, if your down payment is less than 20%, you may be required to pay Private Mortgage Insurance (PMI), which adds an extra monthly cost. Be sure to also account for other costs such as closing costs, property taxes, and homeowners insurance, when budgeting for your home purchase.
Benefits of Following the 5/20/30/40 Rule
Financial rules become popular when they have strong benefits associated with them, and the 5/20/30/40 rule is no exception, as it also comes with several compelling advantages.
For instance, by limiting your home cost to five times your annual income and keeping your EMI to 30% of your monthly income, your mortgage payments will remain within a comfortable range. This prevents you from overextending your budget and reduces the risk of financial strain.
The 5/20/30/40 rule also simplifies budgeting by providing clear guidelines on how much you should spend on your home and how much you should set aside for your down payment and mortgage. And when you have the budget sorted, you can build a solid financial foundation, making it easier to save for future needs and goals.
The Drawback
The 5/20/30/40 has several advantages, but it also comes with potential drawbacks.. There can be multiple situations where following this rule may be less feasible.
For instance, in areas where house prices are quite high, adhering to the rule’s strict guidelines might not help. Similarly, if first-time homebuyers have a lower income or significant existing debt, following the rule may be challenging. In such cases, adjustments or alternative financing options might be necessary to make homeownership attainable.
Let’s take an example to understand this.
Rohan and Priya live in Mumbai with their two kids, and the real estate prices are continuously changing. Their annual income is ₹12,00,000, which means, according to the 5/20/30/40 rule, they should be looking at homes priced no more than ₹60,00,000 (five times their annual income).
Additionally, the rule suggests they should ideally make a 40% down payment of ₹24,00,000 and try to keep their EMI to 30% of the monthly income, which is ₹30,000.
Now, living in a metro city like Mumbai can incur higher costs compared to other cities. Their monthly expenses with the rent and household expenses already take up a big chunk of their income. As a result, they may need to reassess their expectations, consider a lower down payment than 40%, or explore other financing options. In simple words, the 5/20/30/40 rule is suitable for a specific income group.
Personalising the Rule
In high-cost areas or with tight budgets, sticking strictly to this rule can be challenging.
In such cases, first-time homebuyers can adjust the guidelines to match their circumstances. For instance, there is also a 3/20/30/40 formula for buying a house. In this rule, all the numbers stay the same except the “3.” “3” in this regard represents the total cost of the house. It should not exceed 3x of your annual income. By limiting your home purchase to three times your earnings, you’ll have more financial flexibility for other expenses and unforeseen circumstances.
Similarly, you can tailor the rules to fit personal needs and market conditions. This might mean looking for more affordable homes, saving a smaller down payment, or extending the mortgage term.
Conclusion
Now that you know what the 5/20/30/40 rule offers and how to tweak it according to your finances, you have a solid foundation from which to start.
The rule also offers a great starting point for first-time homebuyers. If you are one, you can refer to it for buying your dream home while maintaining financial stability. They simply need to assess their current finances and apply this rule to create a practical plan for becoming new homeowners.
