Your risk profile is a combination of your risk-taking ability and risk-taking willingness. As described in detail in this post on risk profiling,
risk-taking willingness deals with behavioural aspects driven by the level of knowledge about personal finance and experience in capital markets. It is the amount of risk you want to take while investing and deals with behaviour like, for example, wanting to invest a lot in stock markets or none at all or balancing the two
risk-taking ability is a reasonably objective metric that deals with how much risk can be taken to save for a goal. Factors like high income, less number of dependants, large corpus and high skill-set in career etc. increase the ability to take more risk
When you have a home loan, your risk taking ability changes immediately. Two sources of risk affect you:
external factors: interest rates, inflation, capital market returns, appreciation in the housing market
internal factors: health, human capital, other goals like retirement
We will discuss each in detail to explain how to manage your investments while having a home loan.
External factors
Economic factors: Interest rates and inflation
The interest rate on your home loan will typically be a floating rate that will fluctuate with overall interest rates in the economy. Usually, movements of the RBI repo rate indicate the direction of interest rates in the economy, while home loans are tied to the Repo Linked Loan Rate (RLLR) or Marginal Cost of Funds-based Lending Rate (MCLR) as per RBI.
As interest rates fluctuate, so will your EMI over time. As the economy matures, interest rates are expected to decrease, taking down the amount you pay per month on your home loan. Similarly, while inflation is also likely to reduce with time, the purchasing power of the money paid as EMI will decrease as well over time.
There are also risks since interest rates can spike suddenly if inflation goes up. This phenomenon will impact your household finances from multiple directions: your day-to-day expenses will go up, your EMI will go up and the impact on your investments will be uncertain depending on the mix of equity, debt and other assets.
Rental income and price appreciation from real estate is cyclical and depends on inflation and demand. If you are counting on steady rental income to offset your EMI cost, you need to be prepared for vacant periods as well as rents not increasing as per your projections. In many metro cities, currently, rents are depressed and have not kept pace with inflation in the last few years. Real estate portals will give you historical rent and price appreciation for your locality to provide you with a realistic picture of your areaās potential.
If you stay in the property and do not plan to sell it soon, you need not worry about price appreciation immediately. However, if you plan to shift 5-10 years down the line, you need to be mindful of the returns you will get when you sell the house.
Given that real estate is an illiquid asset, do not expect to sell immediately at a price of your choice to make a profit. However, if you have paid for a costly property in the hopes that it will appreciate fast, reconsider your options if the price increase is not that high.
Job market and demand for your skills
You need to consider that your current career trajectory will be intact until the end of the home loan period. It should not be that you have a large home loan and lose your job due to factors out of control like a recession in your industry, pandemics or your company downsizing. If you do not have a lot of safety margin in your finances then a job loss for an extended period can be risky. Similarly, if you have assumed two incomes, for example, and one spouse is out of a job for six months, you need to be in a position to pay the EMI. This particular risk is higher in the case of single-income families.
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Internal factors
Health and impact on career
You need to consider what will happen if a health issue stops you from working for an extended period of time. A typical example is maternity and associated complications. You might be required to take bed rest for three months before delivery or cannot return to work for 12 months after delivery. Similarly, issues caused by bad posture, lifestyle diseases and other health-related factors may prevent you from working the hours or in the type of role essential for your career. Your family situation may also change, requiring you to work fewer hours or a career break.
A few examples are:
you need to travel frequently but continuously develop food-related disorders with outside food
you are a freelancer who works 10-12 hours at a desk. Due to bad posture, you are having back pain that impacts the amount of time you can work
your family suddenly requires extra time due to an elder falling sick or child-care responsibilities that you cannot handle otherwise
While some of these health issues are outside our control, maintaining a healthy lifestyle, exercise and diet can minimise the impact of lifestyle diseases on our careers and consequently the ability to repay the home loan.
Effect of human capital: carrot and stick
The phrase ācarrot and stickā is a metaphor for the use of a combination of reward and punishment to induce a desired behaviour. - Wikipedia
We all know that we need to develop certain habits to improve our lives and careers. For example, eat healthy, exercise more, improve our skills to get salary hikes, look at secondary sources of income, among others. While everyone will agree that such ācarrotsā are good to have and highly desirable, it is also true they are not effective as means of behavioural change.
On the other hand, āsticksā work better at motivating us to improve. For example:
not making required dietary changes will make things worse for a diabetic
not learning new skills will undoubtedly lead to a job loss in some industries
not increasing income will make it impossible to pay off a large home loan relative to other goals
We know that we can use our human capital, as described here āYour human capital, not investment returns, is your biggest wealth creatorā, to increase our income. When ācarrotsā fail to get us to take action, the āstickā of a large home loan might spur people into serious effort to work towards
learning new skills to get a better profile or job
aggressively pursue promotions at work
look at their existing skills and knowledge to create a side business or secondary income source
Other goals
You should not take such a large home loan that it prevents you from achieving other goals. This is most important if you consider that you cannot take a loan for retirement. Therefore, investing for retirement gets higher priority over all other goals. Once you get used to a particular lifestyle, you cannot reasonably expect to downsize once you retire. It might not be possible to sell your existing house at the desired price and shift to a cheaper location.
The impact of the home loan on your other goals can be estimated from this post that shows how to calculate what happens when you add a home loan to your other goals like retirement and childrenās future: Goal-based investing: how to purchase your dream home.
Risk mitigation methods
Emergency fund
You should keep a sufficient margin of safety via an emergency fund that will absorb some of the risks described in this article. Health issues, income loss and increased EMI can be absorbed by keeping 6-12 times the EMI in an emergency fund: Emergency fund: what, why, how much to save and where?
Loan or term insurance
A home loan is a secured loan. If you cannot pay the EMI due to income stoppage either due to death, health issues or other risks, the bank will repossess the house. There are several ways to mitigate this:
loan insurance whose premium is included in the loan. Banks generally include this insurance policy while disbursing the loan and the increase in loan amount is significantly less compared to the benefit
Since most home loans are floating rate loans, there is always the risk that EMIs will increase when interest rates rise. This increase will directly impact your household budget that can be mitigated by an EMI buffer fund.
Please use the sliders below to understand how much your EMI changes when rates rise/fall:
The concept of goal-based investing offers an easy way to adjust your investments once you have a home loan or are planning to take one soon. The approach here is that you invest for paying your future EMIs as goals which ensures that you do not take excessive risk in your portfolio nor borrow too much that other goals are impacted. We will use the Plan Excel sheet to calculate. The plan will tell you:
what asset allocation do you need to have in debt and equity before and after the home loan
how much do you need to invest in equity and debt options every month to ensure you can pay off the home loan
what kind of shocks your portfolio can take since you can adjust the loan interest rate, tenure and rental income
you can stress test your income by lowering the amount of future income growth you are assuming to reach your goals, including home loan
The base case, without home loan, is this:
Case 1: No home loan yet
We will assume a home that costs ā¹ 80 lakhs today (including registration, stamp duty and brokerage) and will be bought in five years. The house will be 75% financed by a home loan (ā¹ 60 lakhs), and the rest will be saved as a down-payment (ā¹ 20 lakhs). These costs will go up over five years at an inflation of 5%. Currently, the family is paying ā¹ 20,000 rent/month, which will also increase by 5%, and taxes/maintenance and other costs, less any income tax deduction, will be ā¹ 3,000/month.
After five years at 5% inflation, the down-payment will become ā¹ 25.5 lakhs, and the loan amount will be ā¹ 76.6 lakhs. At a 7% interest rate, the EMI will be ā¹ 88,066 for a 10-year loan.
The goal table will be as shown above. You can see these calculations in the homeLoan tab of the Excel workbook. The family has all other goals set and has ā¹ 50 lakhs as corpus already saved.
If you add the home loan, you get the updated figure by setting a value 5 in the cell beside āHome purchase after x years,ā i.e. C11.
(click to open in a new tab)
Case 2: You already have a home loan
If you have a home loan already, the adjustment is like this:
calc sheet: Setting a value 1 in the cell beside āHome purchase after x years,ā i.e. C11, since you will be paying the EMI every year
homeLoan sheet: set inflation and the down payment to zero (since you already have paid the down payment), and since you are staying in your own house, the rent paid today will be zero as well
entire the desired payment period, or the outstanding loan period, which ever is lower for āLoan duration.ā
enter the current outstanding loan amount as the āLoan amountā
Once done, the assets sheet will tell you the information you need regarding the asset allocation of your existing funds and SIP amounts.
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This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.
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This post titled How does your risk profile change with a home loan? first appeared on 15 Feb 2022 at https://arthgyaan.com
