The Concept of Affordability: Managing Personal Finance

The concept of affordability states that a thing is affordable if its cost is lower enough for us to buy it. Please note the underlined words “cost is lower“. It means a thing becomes affordable if its cost is low.

Let’s add another layer to it.

Suppose there is an item whose cost is say Rs.25,00,000. How does this item sound to you, affordable or unaffordable? I’m sure the majority will find it unaffordable.

So here comes a critical question. Does the high cost of an item make it unaffordable? No, the concept of affordability stands on two legs. Cost is only one leg of affordability. The other leg is “once ability to pay“.

An item can sound costly, but if one has the ability to pay for it, it becomes affordable.

This is the reason why people with wealth can afford more things than others. Their high ability to pay makes it easy for them.

The Concept of Affordability – Rules

If we can increase our ability to pay for a costly item, it will no longer remain unaffordable. The affordability is derived from three things. Income, savings, and our ability to borrow money.

To make the decision-making more precise, I’ve set rules for myself to judge if an item is affordable or not. Take a look.

The Concept of Affordability - What is An Affordable Item
  • Rule#1. Income vs Cost: Suppose my income is Rs.100. I want to buy an item whose cost is Rs.25 (25% of income). As per the set rule, any item whose cost is more than 10% of income is not affordable. But before concluding, we will apply the next two rules.
  • Rule#2. Savings vs Cost: We must build savings before making purchases. Even if we have to buy a phone, TV, furnitures, vacation, car, home, etc, it must be done from savings. Furthermore, savings built for one item cannot be use for the other. Suppose the cost of a TV is say Rs.100. If Rs.100 or more savings is build for the TV, it will be an affordable purchase. In terms of income, cost of TV is 100% of income, but it is affordable as enough savings are available.
  • Rule#3. Loan vs Cost: Once ability to pay the loan EMI’s can make an item affordable. The rule is, if the loan EMI is less than 5% of income, we can call it an affordable purchase. For home purchase, the loan EMI limit can be extended till 25%.
Practical Application of The Three Rules

How to read and apply the rules?

An Example. Consider a person whose monthly income is Rs.2,00,000. An item (not home) costing Rs.25,00,000 will be an affordable purchase for him?

We can apply the rules as shown in the below infographics.

The Concept of Affordability - Decision Making
  • First: The maximum money that the person can draw from his income is Rs.20,000 (20% of income).
  • Second: The maximum loan tha the person can avail is Rs.10,00,000. How? Loan of this amound will cost an EMI of Rs.10,000. It is falling within the limit of 10% of income.
  • Third: Suppose the person has accumulated Rs.8,75,000 worth of saving for this item. The quantum is 35% of the total cost (Rs.25,00,000). Ideally it should be 100%, but for the moment, this is all that is available.

Adding the amounts shown in the above three steps gives us the value of Rs.18,95,000 (=20K+8,75L+10L). This is the affordability number. As the cost of the item is Rs.25,00,00, the item is not falling within the affordability limit.

A False Sense of Affordability

The above example shows how a combination of income, savings, and a bank loan can finance a purchase. But there were some rules to be followed to judge if we are overspending.

But we overspend, right? The most likely cause of overspending is digging too deep into loans to finance a purchase. Check this video on loan causing overspending.

It is understandable that people fall prey to bank loans. Suppose one is desperate to buy a car for himself. But the cost is not falling within the rules shown above. In such a case, instead of procrastinating, he will opt for a car loan to quicken the gratification.

The loan becomes an easy escape route allowing oneself to spend beyond the means. How?

Loan Sounds Affordable

Suppose one’s income is Rs.2,00,000 per month. This person can get a personal loan of up to Rs.60 Lakhs for a 7 year period. For the borrower, the cost of this loan (EMI) will be about Rs.99,000 per month. Calculate your loan eligibility using this calculator.

So, the lender is ready to issue a loan whose EMI is almost 50% of the borrower’s income. For the bank, this much loan looks safe. But for the borrower, paying almost 50% of one’s salary in EMI will be affordable? Not at all. But people still fall into the loan trap.

We get confused thinking that if the bank is issuing me so much loan then that must be my affordability. This is a wrong understanding.

As per my rule, the following should be the loan eligibility of a person earning Rs.2,00,000 per month:

The Concept of Affordability - Loan affordability rule

If I’m buying a home (residential property), my loan EMI should not be more than 25% of my income. Similarly, if I’m buying anything else, the loan EMI limit should be below 5% of income.

[P.Note: Here I’ve assumed that I’m not carrying any other loans. Hence my present liability related to loan EMI’s is zero.]

In the above example, suppose one is already paying a personal loan EMI of Rs.4,500. In this case, the person can take a new loan of not more than Rs.5,500 per month. The reduced loan eligibility will also reflect in a home loan. The person can now take a home loan whose EMI is limited to Rs.45,500.

Avoiding Loans Alltogether

Almost all financially independent people suggest a loan-free life. But this feeling is not echoed when we watch TV or hear the governments across the globe.

So to say, on one side, experts are telling us to avoid loans. On the other side, government and banks want us to take the loan. Why this fallacy? Who is right?

Banks and our Governments have their vested interest in telling us to take loans. Banks earn money when we borrow loans from them. Bank loans substantially increase our liquidity. Hence, we mostly use it to trigger a bulk purchase. The more people will spend, the faster the country’s GDP will grow. Simultaneously, the Government will also earn more tax revenue.

We must have a mindset to avoid loans in the first place. It is the first step towards understanding and implementing the concept of affordability. Hence, in this case, what experts are saying is more apt for us.

Conclusion

In our venture to buy good and useful things/services for ourselves, we must keep a check on overspendings. How to do it? It can be done by being aware of one’s affordability to buy a thing. Let’s show you an example, info-graphically.

Here is an example of affordability analysis done for a person whose monthly income is Rs.2,00,000. The person wants to buy a sofa worth Rs.1,20,000. He wants to know whether he can afford it or not. Here is the analysis he did for himself:

Affordability Analysis - Furniture

The person’s furniture affordability is only Rs.7,000. Why? Because he has already bought an item worth Rs.15,000. Hence what he can draw from his monthly paycheck is only Rs.5,000.

Moreover, he already has an existing loan (personal) whose EMI is about Rs.10,000 per month. Hence, is not allowed to take another personal loan.

As he has only Rs.2,000 worth of savings under the head “Furniture”, it means his affordability is only Rs.7,000 (Cash from salary is Rs.5,000, and cash from savings is Rs.2,000).

It is a point worth noting that, though the person’s total savings is Rs,3,93,000 still he is not able to buy furniture worth Rs.1,20,000. Why? Because he can consume only the money assigned under the head “Furniture.”

I hope you liked the article. What is presented here is one of the simplest applications of the concept of affordability. It has the power to bring down one’s overspending habit to almost zero.

Keep reading and have a happy investing.

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Hi. I’m Mani, I’m an Engineering graduate who in pursuit of financial independence, has converted into a full time blogger. After working in the corporate world for almost 16+ years, I bid it adieu....read more

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