If you’ve ever felt like your personal finances are slipping through your fingers, don’t worry; you’re not alone. Managing money effectively can be challenging, but some key principles can make a world of difference. In this blog post, we’ll explore the best financial planning thumb rules to help you regain control of your finances.
The Context
Even if we remain flexible, we need some ground rules — Horst Seehofer
Making informed financial decisions is the cornerstone of defining our life’s quality.
If you are unfamiliar with personal finance fundamentals, this article will undoubtedly put you on the right path toward financial success. Most people are hesitant to contact qualified advisors for a variety of reasons, especially those who are in the middle of their financial journey.
These factors usually boil down to ignorance, social stigmas, financial constraints, problems with trust, and barriers to access. In this post, we’ll concentrate on the Top 10 basic “Rules of Thumb” to provide you with a general idea of how to handle your hard-earned cash.
🖱 If you find yourself in a challenging circumstance after reading this piece, seek professional assistance by speaking with a licensed, fee-only financial advisor.
These guidelines might help you establish a strong basis for a quick financial expansion up until the point where you feel the need to do so.
1. The Rule Of Paying Yourself First
The most quoted adage in writing on personal finance and retirement planning is to always pay yourself first. It serves as an illustration of basic investor intelligence by automatically deducting a certain amount from each paycheck as soon as it is received.
According to this rule, contributions to your savings or investment account are automatically transferred from each paycheck. In other words, you take care of yourself before you take care of any monthly responsibilities, such as paying your utility bills or making choices for your material consumption.
This guideline offers a technique for making do with a bit less cash than you would receive from your employment. Additionally, repetition teaches your brain to budget everything so that it fits within the funds that remain after deducting your stake.
2. The Rule of 10/15/35
Paying yourself sounds great, but determining how much to pay (save) is a constant source of confusion. This rule is ranked second on our list of the top 10 financial planning thumb rules.
This rule indicates that you should set aside at least 10 percent of your post-tax income when developing your career, usually between the ages of 20 and 25.
Your monthly savings rate should be increased to 15 percent as you become older and start earning more steadily when you hit your 30s. This holds true despite the increased obligations. As you become older and reach your forties, you should consciously increase your savings goal to 35 percent (of your after-tax income) for your long-term objectives.
You should always identify a clear investment purpose by the time you reach your forties to stay on track as financial stability, spending, and liabilities usually stabilize at this age.
3. The Rule of 50/20/30
Spending a portion of your income is crucial since saving and spending are two sides of the same coin. The line between being economical and being cheap is a clear one. While you’re trying to be frugal, don’t accept inferior products.
This is essential if you want to keep your level of life and your inspiration high. As a result, this rule is ranked third on our list of the top ten financial planning thumb rules.
The guideline significantly reduces the mystery surrounding how much money should be saved and spent!
This rule states that you should allocate 50 percent of your income for living expenses (housing, lodging, and groceries), 20 percent for short-, medium-, and long-term goals, and 30 percent for discretionary expenses like outings, entertainment, fine cuisine, and travel.
The idea behind this is to aggregate and bucket money outflow by a threshold cap. The percentage allocation can be changed because it is a subjective regulation depending on your age, preferences, and financial situation.
4. The 20/4/10 Vehicle Rule
Purchasing a vehicle is not a minor investment. With the average lifespan of an automobile now being eight years, your car will be by your side for a very long time and will get you where you need to go.
When buying a car for yourself, the 20/4/10 rule helps you make wise, rational choices despite the temptations like the Ferraris, Mustang, and Tesla out there.
The basic premise is that you should never finance a vehicle for more than four years, put at least 20 percent down on it, and limit your monthly automobile expenses to no more than 10 percent of your total income.
The 20 percent down payment assists in lowering the amount of debt that causes long-term capital degradation. A 20% down payment also increases your likelihood of getting a loan approved.
4 years of wear and tear on most new vehicles results in greater maintenance expenditures.
If you decide to sell your asset rather than spend extra money on repairs, the 4-year loan term frees it up. Finally, for good reason, the whole cost of your vehicle (including loan payments, gas, insurance, and road tax) should not exceed 10 percent of your gross income.
You probably won’t have enough money left over at the end of the month for savings or investments if you consistently spend more than that (unless you professionally drive an Uber for a living).
5. The Rule Of Emergency Fund
The fifth guideline on our list of the top 10 financial planning thumb rules is to have an emergency fund, which functions as the heart of your financial engine. The continual threat of financial difficulties prevents us from taking essential chances in life.
An unexpected expense, such as a car breakdown, an urgent house repair, a painful layoff, or worse, an emergency medical situation, might trigger a financial crisis. An emergency fund serves as a safety net for life’s harsh knocks, ensuring that you never falter in your financial endeavors.
In conclusion, an emergency fund is a sum of money set aside for unforeseen financial circumstances. Keep in mind that your emergency fund isn’t always expected to produce higher returns or profits.
Sometimes, it might just be sitting there acting as insurance, providing safe, modest profits that can be cashed in on when needed.
Parking money in fixed-income products like fixed deposits or liquid funds will help you do this.
As a generally recognized guideline:
1. If you have a steady job, you should establish an emergency fund with at least three months’ worth of spending.
2. If you work as a consultant, contractor, or in a seasonal job, this sum should cover your costs for at least six months.
3. If you own a firm or are an entrepreneur, this sum should cover your expenses for at least a year.
The only costs you should take into account for an emergency fund are those necessary to maintain a meager, day-to-day existence (food, clothing, lodging, or emergency medical treatments).
Never use more money from this budget than necessary for luxuries like outings, parties, bargain shopping, or relaxation.
6. The Rule Of Life Cover
The sixth slot on the list of the top 10 financial planning thumb rules belongs to this significant rule. As a general rule, you should have life insurance coverage equal to at least 10 times your yearly pay.
For instance, if your annual take-home pay is ₹20 lakhs, your insurance coverage should be at least ₹2 crores or 10 times that amount. Depending on your age, ambitions, dependents, and earned net worth, a skilled and competent (registered) financial advisor can help you determine just how much coverage you’ll need.
This is possible with the different pure-term insurance plans that are currently offered at affordable costs.
7. The Rule Of Equity Investments
This one is also referred to as the “100-minus-age rule“.
Everyone agrees that when investing, one should think about a combination of equity (stocks) and debt (low-risk, fixed-income instruments). According to this formula, your portfolio’s equity proportion should be equal to 100 minus your present age.
For instance, if you are currently 30 years old, your maximum stock exposure should be 100 minus 30 percent or 70 percent. In your 40s, you should adjust this percentage to 100 minus 40, or 60 percent. As you age, your equity exposure as a proportion eventually decreases.
This guideline is founded on the fundamental idea of balancing the risks associated with market volatility, which frequently calls for conviction and patience amid challenging market conditions. As you move closer to your life goals, the debt part enables you to weather the storm without being shocked.
Depending on your market expertise and risk tolerance, this rule is somewhat negotiable. If you know what you’re doing in the stock markets, the 110 minus the age guideline also works nicely.
8. The Rule Of Net Worth
The version of this rule that makes the most sense to us is the one presented by Thomas J. Stanley in the highly recommended book The Millionaire Next Door.
He argues that your net worth should always equal your age times your pretax income, then divided by ten at any given time. As an illustration, if you are 30 years old, earn a pre-tax income of ₹20 lakhs per year, and do not receive any inheritance, your net worth should be (30*20)/10 = ₹60 lakhs.
Keep in mind that your net worth also includes investments, real estate, jewelry, equipment, and other transferable assets like art, paintings, and rare collectibles in addition to cash and cash equivalents (minus any loans or liabilities).
Low net worth can be a warning sign that your ability to handle your money needs to be re-evaluated.
9. The Rule of 30/100 EMI
We’ve reached the ninth rule on the list of the top 10 financial planning thumb rules since we all have the propensity to overdo things. This guideline, which establishes the maximum amount of your combined EMI outpour, is a no-brainer.
Since EMI significantly reduces your monthly budget, it should not be more than 30 percent of your pay to retain creditworthiness. The largest amount of debt that most people have to pay back in their lives is typically their home loan EMI.
But did you know that many people are denied loans because financial institutions consider borrowers’ current debt obligations before approving loans for the purchase of a home or other property? These obligations include the EMIs you already pay on your credit cards, personal loans, and auto loans.
In general, they won’t give you money if your monthly EMI surpasses 45 to 50 percent of your take-home earnings. This ratio is referred to as “income-to-EMI.”
The optimal “income-to-EMI ratio” shouldn’t be more than 30 percent, if 50 percent sounds excessive unless you have mastered living off half of your wage with little chance of savings. Instead of losing your sleep and peace of mind, it is preferable to live within your means and gradually raise or expand your standard of living.
10. The Rule of 72
One of the most intriguing financial principles compares the caliber of your investment to the amount of time you have to attain your financial objective. This approach provides an estimate of the number of years needed to double your invested capital based on the instrument’s return yield.
For instance, if your stock portfolio has the potential to yield 15 percent returns per annum then simply divide 72 by 15. So, 72/15= 4.8 years. This means that if an investment yields a 15 percent annual return, compounded annually, it will take 4.8 years to double.
Another illustration — Divide 72 by 10 if your bond portfolio has the potential to return 10 percent annually. Thus, it will require 72/10 or 7.2. In other words, if an investment earns safe returns of 10 percent annually, it will take 7.2 years to double it.
Conclusion
Even though these “Thumb Rules” are not always inflexible, they have generally acknowledged guidelines that aid in the analysis and direction of our day-to-day financial choices for a bright future.
Similar to how each person’s approach toward investing is different, no one rule is ever anticipated to apply to all investors. They do, however, aid in highlighting the essential problems that necessitate a more thorough examination of the current state of affairs.
Frequently Asked Questions (FAQs)
1. How can I start managing my finances effectively?
Effective financial management begins with understanding some key principles. It’s essential to pay yourself first, set savings goals, budget your expenses, and prioritize financial stability. These steps can help you regain control of your personal finances and work towards your financial goals.
2. What are some basic rules of thumb for financial planning?
There are several basic rules of thumb for financial planning, including paying yourself first, saving a percentage of your income (such as the 10/15/35 rule), budgeting your expenses (following the 50/20/30 rule), and maintaining an emergency fund. These guidelines provide a framework for making sound financial decisions.
3. How can I make wise decisions when purchasing a vehicle?
When purchasing a vehicle, it’s important to follow the 20/4/10 rule. This rule suggests making a 20% down payment, financing the vehicle for no more than four years, and ensuring that your total monthly automobile expenses do not exceed 10% of your gross income. Following these guidelines can help you make a wise and rational decision when buying a car.
4. Why is having an emergency fund important?
An emergency fund serves as a safety valve for unexpected financial challenges, such as car repairs, medical emergencies, or job loss. Having an emergency fund ensures that you have funds available to cover essential expenses without relying on credit cards or loans, helping you avoid financial stress and instability during difficult times.
5. How much life insurance coverage do I need?
A general rule of thumb is to have life insurance coverage equal to at least 10 times your yearly income. However, the appropriate amount of coverage may vary depending on factors such as your age, financial obligations, and dependents. Consulting with a licensed financial advisor can help you determine the right amount of coverage for your individual needs and circumstances.
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3 Comments
The rule of net worth turns out to be a bit worrisome. I have decided to read the book mentioned up there.
It’s a wonderful read Adarsh, do share your reviews about the book in our forums.
Great pointers to manage personal finance. I wonder if we could have some listed out specifically for stock investing.