When it comes to personal finance, people often wonder –
- How much life insurance cover do I need?
- How much do I need for my retirement planning?
- How much should I spend to buy a car?
As personal finance is ‘personal’, there are no hard and fast rules for these things. It all depends on your current financial situation, your risk taking ability and your financial goals. But still, some basic thumb rules are there which would hopefully solve those puzzles and guide you towards financial stability and help you achieve financial freedom in the long run.
Thumb Rules of Budgeting
If you want financial wellbeing and stability, always try to live below your means. Great investors like Warren Buffet lives life frugally and motivates us to do so too. When we live frugally and buy only what we NEED rather than what we want, and when we learn to seek value for money and stay within our budgets, we help ourselves save more, invest more and create a financial safety for ourselves to protect us in times of an emergency.
1. 50-30-20 Rule
The 50-30-20 rule is about Expense vs Savings. As a basic thumb rule, you should
- Spend 50% in Needs (rent, groceries, medicines, EMIs etc.)
- Spend 30% in Wants (entertainment, vacation etc.)
- Put 20% in Savings (long-term goals – FD, Equity, MFs, PPF etc.)
If your monthly income is 50,000, you can spend 25,000 to run the households, 15,000 on vacations, celebrations, gifting etc.
And most importantly, you should put at least 10,000 into savings. The more the better. It’s important to automate your savings in the likes of SIPs, PPF, RD etc. so that you follow a disciplined way of saving and investing.
2. 40% EMI Rule
Your total EMI for loans should never go beyond 40% of your monthly income. If your income is 50,000 per month, don’t take EMIs more than 20,000. The less the better.
3. Can buy twice?
Before any expensive buy, ask yourself “Can I afford to buy it twice?”. If the answer is yes, only then go for it.
Suppose you are willing to buy an expensive iPhone for Rs. 1,40,000 on an EMI. Ask yourself if you have the financial position to buy two such phones now. No? Then it’s better to leave the idea and rather go for a phone at a lower cost that you can easily afford.
4. Home Budget
You shouldn’t buy a home more than 5 times your annual income. If you earn 5 lakh per year, your maximum budget for buying a home should be 25 lakh.
5. Car Budget
Your car price shouldn’t be more than your 6-month salary. If your monthly income is 1 lakh, stay within a budget of 6 lakh if you decide to buy a car.
Thumb Rules for Financial Emergency
The world has seen financial emergencies in the times of global wars, pandemics and financial recessions. At those times many people lose their jobs, many people default on their loan EMIs and have to sell their homes, cars and other valuables, businesses go bankrupt, banks collapse and so on. That is why we need to remain well-prepared for such a crisis period. After all, emergencies are sudden and unexpected.
6. Emergency Fund
You should have 3- 6 months of your income as an emergency fund.
- For salaried people, 3 months salary
- For self-employed, 6 months income
This amount should be kept aside in a bank fixed deposit (FD) or in a liquid debt mutual fund so that you can access the money any moment easily in case you need.
7. Life Insurance cover
You should take a term insurance plan worth 20 times your annual salary. If your annual income is 5 lakh, you need a term plan of 1 crore.
Thumb Rules of Investing
Well, investing is one of the most important things in your financial journey. You should have a mix of both debt and equity instruments in your investment portfolio. While debt instruments (debt mutual fund, fixed deposit, PPF etc.) gives you stability and protects your wealth, equity (equity mutual fund, index fund, ETF, stocks etc.) brings you growth. But, how much should you allocate to equities? Let’s learn.
8. ‘100 – your age’ Rule
This rule is related to asset allocation in investments. You should allocate (100- your age)% of your total savings to equities, and the rest should go towards debt instruments.
So, a 30 year old should allocate 30% to debt and 70% to equity, but a 60 year old should allocate 60% to debt and 40% to equity.
9. Diversification
Your investment portfolio should have a maximum of 10 mutual funds (Equity, Debt & Hybrid funds all inclusive) and 15 stocks. The less the better.
While diversification is a good strategy for protection against uncertainties, overdiversification can backfire. When you diversify a lot, it’s difficult to keep track of those investments. A person with a regular job can track mostly 10-15 businesses over the longer period.
10. 4% Withdrawal Rule
This rule is about retirement planning.
- Your retirement corpus should be 25 times annual expense.
- Keep 50% of that money in debt and 50% in equity.
- Withdraw 4% every year from the debt fund and keep rebalancing the debt-equity allocation to 50-50.
Suppose, you have retired this year and your annual expense is 4 lakh. You should have a retirement fund of 4 lakh x 25 = 1 Crore.
Keep 50 lakh in low risk debt (fixed deposits, debt mutual fund etc.) and 50 lakh in equity (index fund, ETF etc.). If we assume a conservative 4% annual return on debt fund and 8% return on equity, next year the amount becomes 52 lakhs and 54 lakhs respectively.
Now, withdraw your annual expense of 4 lakh from debt fund. Now the debt fund becomes 48 lakh and equity remains 54 lakh. Take 3 lakh from equity and put it to debt to make it equal again (51 lakh each). This way you can continue to meet your expenses and also holding your wealth.
Hopefully, these personal finance thumb rules will help you take better decisions and a disciplined approach to manage your finances well.