Financial planning thumb rules

Financial Planning

Rules of thumb may come in handy for those who are just beginning their financial planning. Youngsters who have just started their career may get some direction on where and how to make a beginning. For those who are in the middle of their career and don’t yet have a proper plan in place, thumb rules can also be helpful. But remember, they only provide a general direction and may not necessarily give you the exact picture.

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 RuleĀ 
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.

Emergency fund
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.

Life Cover

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.

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