Financial planning can be cumbersome. As it requires us to excel in in all aspects surrounding it. These include investing, insurance, estate, tax planning etc. What makes it even more complicated is that it requires us to make decisions.
Decisions about your future. But most of us aren’t even sure of what our next week will look like let alone our financial future. This is where financial thumb rules developed by experts over time come handy.
Financial thumb rules can be a great guideline for new and young investors. As these rules facilitate decision making. They spell out and check if your budget and financial goals are on track. That too in a single sentence. And the ones that accomplish that well are:
The 50/15/5 rule for Budgeting: How much money do I need to save every month?
The rule apportions your monthly income into 3 separate baskets.
50% of your combined monthly income should be allocated to your household expenditure.
15% should be used for retirement funding or any other long-term financial goal
5% for the unexpected expenses in the form of short-term savings
It’s a great starting point for financial planning. Which you can alter to suit your individual needs. Maybe you need to repay some debt or are looking to buy a house shortly. In which case you must ideally repay debt first and save later.
Breaking down your monthly expenditure into these basic categories is extremely helpful. It highlights and differentiates between your needs and wants. It also helps you identify the areas where you’re overspending and encourages you to make better spending decisions.
Emergency fund: How much money should I keep aside for emergencies?
The need for an emergency fund has never been more apparent. These difficult times highlight the importance of money kept aside earmarked for emergencies. Preferably in a safe, liquid and accessible investment instrument. But how much money is required for emergencies?
Don’t go by what others have to say. Every family’s situation is different. You might be a double incomes families, or have prior commitments like EMI etc.
Hence you must decide depending on your situation. But a good thumb rule that works in every situation is to keep 6-9 months of living expenses aside. These are your basic expenses like your monthly grocery bills, EMI, dining out and entertainments costs, child’s education etc. The key is to have enough to manage your expenses if you suddenly find yourself without any source of income.
Insurance thumb rule: How much life insurance coverage do I need?
There are several ways of determining how much coverage you need. You can tie your coverage to your annual income, including your bonuses and other perks. A good thumb is to opt for a life cover which is 8-10 times of your total annual income.
But much like the other thumb rules take this is only a starting point. You must work out a plan incorporating your aspects of the financial situation. Such as the capital you've accumulated, liabilities you've accrued and the specific costs you’d like your family to be covered in the future.
The most cost-effective way is to buy a pure term insurance plan. It is a low premium, high-cover protection plan where the primary focus is risk coverage. But buy a policy with premiums you can afford in the future. As it's better than buying a bigger policy whose premiums payments you cannot honour.
The home loan rule: How much home loan can I afford?
I’m afraid the lenders have decided that for you. The lending process most lenders follow more or less decides this for the borrower. Before lending, lenders have to check the borrower's existing loan commitments. They only sanction:
loans up to 75%-85% (sometimes 90%) of the property value and
whose EMIs (monthly outgo) is not more than 45-50 per cent of the monthly after-tax income.
These include any other existing loans or EMIs on (car or personal loans). A good rule to minimise your total monthly outgo on loans. Keep them all under 50%.
But a common mistake home-buyers make is that they forget to factor in the other costs in their loan component. These include stamp duty charges, broker’s fees, loan processing charges etc. Which can quickly add up and amount to around 2-3% of the total home value.
Keep in mind that smart and informed financial planning lies at the heart of any prudent investment strategy. And these thumb rules serve as a great starting point for those who are new to saving and investing.