Financial planning thumb rules
For those who are in the middle of their career and don't yet have a proper financial plan in place, thumb rules can also be helpful.
First rule first
The very first rule of personal finance says: 'Pay yourself first'. It simply means that out of your monthly income, a certain percentage has to be saved before it is spent. 'Income minus savings equal to expenses' should be the rule and not vice-versa.
For this to happen properly, identify your goals, estimate the inflation-adjusted requirement and then find out how much you need to save for them. Now make sure that each month funds move out from your salary towards your goals, and manage your household expenses with what is left. You, in a way, are first paying for yourself, i.e., your goals.
How much to save
As a rule, 10 per cent of the post-tax income of those starting their career at around age 25 can be the starting point. Over time, as the income increases, shoring it up to 15 per cent can give you a good head start and a buffer. As you grow older, and your income rises and financial liabilities add up, make sure you are saving enough towards your goals. In middle age, saving at least 35 per cent of your post-tax income should be the benchmark, as expenses during this period typically increase.
The 50-20-30 Rule
Confused about how much to save and spend each month? Here's how to get started. It's the 50-20-30 Rule, i.e., 50 per cent of your income should go towards living expenses, i.e., household expenses, including groceries; 20 per cent towards savings for your short, medium, long-term goals; and 30 per cent towards spending, including outing, food and travel. The idea is to create outflow buckets for better control. Individuals may tweak the percentage according to their age, circumstances, etc.
The 20/4/10 Rule
This rule helps keep your finances under control when you're buying a new car. Twenty stands for the down payment amount, as 20 per cent of the car price should be paid by you. It's, however, better to make as much down payment as possible. Four stands for the number of years of financing. Although lenders have a tenure of up to 7 years, it's better to stick to 4 years. Ten stands for the ideal percentage of your net-take home salary that should go towards car loan EMIs.
As the name suggests, an emergency can happen anytime and needs immediate action. There could be a setback to one's earning capacity due to a temporary disability or being unemployed for a few months. A medical emergency may crop up at a time when the settlement claim is taking time, or the ailment itself may have a waiting period. In such cases, one may have to arrange for funds to tide over the situation. Whether it's meeting the household expenses or honouring commitment towards EMIs, certain cash outflows are sacrosanct. An emergency fund is not aimed at meeting your planned goals, but it only acts as a safety net.
Although there's no fixed rule on how much emergency cash one would need, ideally 3-6 months' household expenses should be one's emergency fund. The amount should help you to combat financial emergencies.
You should ideally have a life cover which is at least 10 times of your annual income. The actual requirement may, however, depend on one's age, goals to be achieved, financial dependents, accumulated wealth, etc.
The most cost-effective way of buying life insurance is through a pure term insurance plan. It is a low premium, high-cover protection plan where the premium goes entirely towards risk coverage, i.e., to cover the mortality risk. Therefore, on surviving the term, one doesn't get anything back as there is no savings portion of the premium. But that should not deter someone from buying a term plan as risk cover through life insurance as it is one of the basic necessities in one's overall financial plan.
How much to save for retirement
Most financial planners suggest a retirement corpus target which is about 20 times of one's annual income. Some feel that 30 times can be a better figure as it will take care of inflation. It gives you a reason to work backwards and estimate how much you need to save from today till you retire.
Still, this rule may leave you disappointed as it takes income and not expenses into account. Also, it may work for those whose retirement is years away than those who are retiring soon.
By keeping three things into consideration, i.e., the take-home income, the down payment amount and the home loan interest rate, one can figure out the worth of the house that one can afford to buy. If one is buying a home with a down payment of 20 per cent and the rest on a home loan, and also keeping the income-to-EMI ratio in mind, the affordability arrives at about 4.5 to 5 times of one's annual income. In other words, one is buying a house which costs about five times of his income. Therefore, when real estate prices go up, affordability becomes a concern, unless income also moves in tandem.
Before lending, the lender finds out the borrower's existing loan commitments. Banks don't lend an amount on which the EMIs will be more than 45-50 per cent of the monthly take-home pay. And this includes any other existing EMIs on car or personal loans.
Ranjit Punja, CEO & Co-founder, CreditMantri, says, "Monthly EMI on the home loan should be less than 30% of monthly income. Total EMI obligations (home plus others) should ideally be less than 50% of monthly income."
But what if the existing loan is nearing completion? Satyam Kumar, Co-Founder, Loantap, says, "Loans where only 12 or less EMIs are pending are not factored towards loan eligibility, so you get higher eligibility." The income-to-EMI ratio should be close to 50 per cent and not higher else a lesser loan amount gets sanctioned and it might disturb your household cash flows.
Also, a high credit score may not necessarily be enough for securing a loan on the best terms and conditions. Punja says, "Ensure that your credit score is 750 plus so you can get the best terms."
How much to invest in equity
It's often said that one must use the '100 minus age' approach as far as investing in equities goes. So for a 30-year-old, 70 per cent of his investible surplus should be in equities, while the rest in debt. As one ages, the allocation towards equities falls as it is considered more volatile than debt. It could be a good way to begin but over time, allocation into equities will depend on the tenure of your goals. For long-term goals such as retirement, being aggressive in equities will help, till at least three years before retiring.
The authors of the book The Millionaire Next Door had framed this rule to arrive at the required net worth. The net worth, according to them, should equal your age multiplied by your pre-tax income, divided by 10. That number, minus any money that you inherit, should be your net worth for your age and income.
So if you're 40 and make Rs 20 lakh a year, you should have a net worth equal to Rs 80 lakh, assuming you have no inheritance. If you want to secure your position as wealthy, your net worth should be double that number.
Remember, your net worth is your assets minus your liabilities, and your assets include not only your cash, investments and home equity, but also tangible property such as jewellery and furniture. Your house remains a contentious issue as far as adding it to the net worth figure goes. So it's better to exclude it while calculating your net worth, unless you are ready to move to a smaller house in future.
When it comes to mutual fund schemes, investors are known to hold a many as 30 different ones. Over-diversification may not necessarily help in obtaining the right result for the portfolio. J.L. Evans and S.H. Archer have shown in their research that most diversification benefits are obtained with about 10 funds. Adding more funds still provides benefits, but the gains seem marginal compared to the drawbacks of managing the enlarged portfolio.
Rule of 72
To calculate the number of years in which your investment will double -- it is known as the rule of 72 -- simply divide 72 by the rate of return that you can generate.
So at 12 per cent return, you can double your money in six years. No. of years = 72/12 = 6.
To know the time required to triple the principal amount, the rule of 114 is used.
The amount of time needed to triple your money would be = 114/12 = 9.5 years.
Rule of 72: Number of years to double = 72/expected return.
Rule of 114: Number of years to triple = 114/expected return.
Rule of 144: Number of years to quadruple = 144/expected return.
There's no 'one size fits all' approach. Your finances need to be personalised according to your risk profile, situations, etc. Once you have made a start using the thumb rule, it is important to review things over time and make any changes to your plan accordingly.