The 40% Rule: A Simple Principle That Can Save You From Falling Into Debt Trap

Many Kenyans are often tempted to take loans for cars, homes, or business ventures to meet their financial needs. However, without proper debt management strategies, these financial opportunities can rapidly become overwhelming burdens that strain your finances.

This is where the 40% EMI (Equated Monthly Installment) rule comes in, a simple yet powerful guideline that can help you avoid falling into a debt trap.

This rule advises that your total monthly loan repayments should not exceed 40% of your monthly net income. To illustrate this, let's consider a practical example for an employee earning a gross salary of Ksh70,000.

After all the necessary deductions, such as Pay As You Earn (PAYE), Social Health Insurance Funds (SHIF), and the National Social Security Fund (NSSF), the monthly take-home, or net pay, is Ksh 51,594.15.

According to the 40% EMI Management Rule, your maximum total monthly debt payments should be calculated based on your net income.

Calculation:

• Net Monthly Income: Ksh 51,594.15
• Maximum EMI Limit: Ksh 51,594.15  multiplied by 0.40 = Ksh 20,637.66

This figure, Ksh 20,637.66, represents the absolute maximum you should be allocating towards all your loan repayments combined each month, whether it is a sacco loan or a car loan, or bank loans.

Why the Rule is Important

After setting aside the maximum Ksh 20,637.66 for EMIs, you are left with Ksh 30,956.49 (Ksh 51,594.15 - Ksh 20,637.66). This remaining amount must cover a multitude of needs, such as food, transportation, and rent.

If your EMIs were to exceed the 40% mark, let's say 50% or 60% of your net pay, you would find it nearly impossible to meet your basic needs without falling into financial distress.

Practical Ways to Apply the 40% Rule

For a salaried Kenyan, this rule helps determine whether they should take up a loan or not.

Example: Let’s say a Ksh70,000 salaried employee wants to buy a car. When they go to a bank, they will be offered different loan amounts and repayment periods. By knowing your maximum EMI of Ksh 20,637.66, you can tell the bank exactly how much you can afford to pay each month and pick the best option for you.

For someone with a good credit report, they can now use this to negotiate for a loan that fits their budget for loan repayments.

Meanwhile, for someone who already has existing debts, and their loan repayments already exceed 40%, they should not take up any new loan. In some cases, one can also go to the banks and seek restructuring of their loans and repayment periods to reduce pressure on their finances.

By understanding and consistently applying this principle, you can make informed decisions, avoid the debt trap, and ensure that your hard-earned money works for you, giving you the freedom to thrive and achieve your long-term financial goals.