5 Simple Rules for managing Your Personal Finance
by Mashum Mollah Finance 02 August 2018
Money might not be everything, but wherever you need money, there is hardly any alternative to opt for. Hence, money management is an area where you need to tread with caution and exercise utmost discipline. While there are a lot of things to be kept in mind while managing your finances, I have tried to list down five principles for money management. These have been inspired from the common trends seen in the contemporary youth.
1. Segregate savings into different investment buckets based on their likelihood of a requirement
Every family, whether predominantly service-oriented or business driven, accumulates only limited savings every month. Our savings should be invested very carefully in different assets in accordance with their likelihood of requirement. At times, our requirements are planned and decided in advance, while at other times, they are unplanned and required almost immediately. Travelling, vacations, fees for higher studies, purchase of electronics, vehicle or a new house, and several other discretionary sets of expenses fall in the first category of planned expenses. However, medical emergencies, urgent travel needs, and financial support to family and friends constitute the unplanned category of expenses. The unfortunate characteristics of such expenses are that these are neither discretionary nor deferrable. We are forced to incur these expenses and often almost immediately. One should always try to match the maturity of investments with likely time of incurring expenditure. Near-term requirements should always be saved and invested in safer instruments such as plain savings accounts, short-term fixed deposits or money market mutual funds. After that, a substantial portion of savings should be invested in fixed deposits or recurring deposits for use in case of a medical or similar emergency. The amount remaining after that, if any, is the actual surplus savings, which should be invested into equities. All surplus savings now should be invested into equity directly or into equity-oriented funds for meeting longer-term goals such as marriage, children’s education or purchase of the house.
2. Insurance and investment must be separated:
There are mostly two types of people in India – one who do not take insurance and the other, who take endowment and money back insurance policies and believe that they have insured their families adequately. I would like to advocate a third school of thought which ensures that you adequately insure your family as well as ensure better returns on your investments. A term insurance is what I suggest every working individual should take up.
Unlike the more popular insurance schemes such as endowment and money back policies, one does not get back the premiums paid upon maturity. However, in the unfortunate event of one’s demise, the nominee gets a very large lump sum. For instance, a 25 year male with no medical illness and addictions can purchase an insurance cover of 1 crore at just Rs. 6000-8000 with the private sector insurers and cover himself for up to 40 years from date of enrolment. The corresponding premium for such a high cover in an endowment policy would be huge and often beyond the reach of a middle-class salaried individual. However, given the rate of inflation in the country and increasingly flamboyant lifestyle changes, a cover of 10-20 lakhs would not be sufficient to cover one’s family in the unfortunate event of one’s untimely death.
Therefore, a term insurance is suggested. After enrolling for a term insurance, one should immediately stop other running life insurance policies, if any, and deposit the surrender value in a mutual fund corresponding to one’s risk appetite. Alternately, start investing annually in a mutual fund, the total amount that you were ready to pay for insurance, after deducting the term insurance premium. After a few years, the corpus would grow bigger than the maximum maturity value under any endowment or money back insurance scheme. And at the same time, your family is secured for a much larger amount than an investment-type of insurance scheme would have allowed. You may enroll for financial planning course for better understanding.
3. Only long-term surplus funds should be used for investment in equities
While the equity markets scale new highs every month and attract new investors, you would find that there are more people who end up losing money than those who gain. The secret of success in equity markets, whether through direct route or through the mutual fund route, is simple, but following this simple rule is very difficult. The formula is straightforward – “Exercise emotional discipline while buying stocks or investing in mutual funds, and invest only that portion of your savings into equities which you might not need even in an emergency.”
Suppose all your investments are into equities and you have a medical emergency for which you need funds. You have no other option but to sell your investments. If the market is going through a weak phase at that very point in time, you have to still sell your investments at a loss. Then it is irrelevant whether you had made a bluechip investment or a small cap trading bet – a loss is a loss! This same stock might start moving upwards immediately after you had to sell it, but you would still have lost your capital. The idea behind sharing such an example is not to scare one away from the equity markets, but to advise what portion of your savings should be invested into equities. No matter how strong your research on equities or how little the likelihood of requirement of funds, do not risk yourself by investing in equities before creating a backup fund for meeting emergency situations in life. Follow this principle and there will nearly never arise a situation when you would end up losing in stock markets and have to borrow money to meet your needs. Also, do not chase high returns in equities by blindly following tips given by people. Invest into equity with the mindset that you are investing in your own business. Would you like to invest in and run a particular business? If yes, only then should you buy that stock.
4. Limit your borrowings to less than 75% of your maximum repayment capacity
Personal loans are quite common these days. Availing a loan is easier than it ever was. Loans for traveling, marriage, medical expenditure or even for investment in stock markets are growing at a rapid pace. While a bit of debt is good for both your CIBIL score and for managing your personal finances, regularly availing loans can push you into a debt trap. The thumb rule banks follow while giving a personal loan to a salaried person is that the maximum EMI paying capacity of a person is up to 65% to 70% of his net monthly salary. For instance, if you earn a net salary of Rs. 100000, you can take loans for which EMI total up to Rs. 70000 at best. My personal take is that we should restrict our borrowing to only 75% of this value. Breaching this limit will soon find you trapped in a web of debt and EMI and years of income shall be lost in repayment of these loans only. Accordingly, in the above example, borrow only up to the extent that your Email does not breach Ra. 50,000.
5. Use credit cards wisely and never overspend in anticipation of future cash flows
Credit cards are an efficient means of managing cash flows and helpful towards the end of the month when your pockets dry up. However, one very important thing to keep in mind is that one must not overspend on credit cards in anticipation of earnings. Spend only as much is necessary and that which can be cleared in the very next month through your salary or earnings. Never pay only the ‘Minimum Amount Due’ on credit cards. Always aim at clearing the entire amount due because the high rate of interest is charged on the deficit. You keep paying the Minimum Amount Due and interest is charged on the balance amount such that the total outstanding at the end of the next month increases beyond the current overdue. Hence, always pay the entire credit card bill and never take a loan on credit cards.
Personal finance is a subject where one needs to exercise a lot of discretion and more often than not, there arise situations wherein you would be tempted towards budging from your set of rules. However, it is almost certain that if we can win over these temptations, we have won over most of our financial needs.
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