Financial Planning Thumb Rules: Don’t be blind!

With low levels of financial literacy, a large section of population in India is unable for making important complex financial decisions. Understandably, the personal finance rules of thumb can serve as an excellent tool for accelerating the level of financial literacy among people and help them develop abilities for making sensible financial decisions. In the context of financial planning, rules of thumb facilitate to get quick estimate of financial number and help to make swift financial decision. They can make financial choices easier and can help overcome the problems of procrastination and low level of financial competence. But they cannot be used as full proof and may not be perfect substitute for proper analysis and customized financial planning. Though personal finance rules can serve as handy means for guiding your money behavior, they cannot fit your financial situation and may be a waste of time or worse, can have serious detrimental impact on your finances. However, they are directional and surely help people in understanding and managing personal finances. The lead article of this issue aims to present a deeper perspective on the effectiveness of the Rules of Thumb in the financial planning process. Here are some of the most frequently used and handy thumb rules used by various personal finance websites to spread finance awareness among the masses. While using the same, it needs to be extra cautious and selective in the use of rules of thumb in the financial planning process on account of the risk of perceived false sense of security they may provide.

Pay-Yourself First Rule

This rule is likely to improve the regular savings habit in people and encourages people to save by setting aside a pre-determined portion of salary every month. The rule overrides the conventional method of expressing saving as residual equation: “Income minus Actual Expenses= Savings” with redefines the saving equation as “Income minus Planned Savings = Money available for expenses”. The standard rule of thumb is to save at least 10 percent of your gross income month after month. This rule gets automatically set your maximum capacity to spend your monthly expenses and inhabitant to make self-discipline for saving in the future. It can be aligned to your saving and wealth creation to long-term financial goals, like retirement corpus and to decide how much you will need to save for it. In addition, it is always recommended to inculcate the habit to increase savings gradually over time and to pursue the Saving Mantra of “Save Now-Save First-Save Regularly” for creating sustainable growth. You can be easily calculated yourself by fine tuning and redefining the future value formula in the context of financial planning. For instance, to create an education fund of Rs 30 lakh (future value) over ten year period at tax adjusted rate of return of 9.50 per cent per annum means setting aside Rs 15,290 per month for 120 months or Rs 1,83,487 per year for ten years from the current income.

Personal Budget Rule

A personal budget is a rudimentary plan that allocates future income towards planned savings, expenses and debt repayment. Its preparation helps in presenting a clear financial picture and more control over spending behavior which helps in reducing financial stress and developing habit to save more. There are several ways of creating and implementing a personal budget. One of the simplest ways of budgeting to save is the 50-20-30 Rule of thumb. The personal budget 50-20-30 Rule divides into three buckets such as your income after tax, funds available for savings, investing and spending. The first 50 percent of the budget goes towards provision of necessities, like food, shelter, clothing, utilities, transportation etc. It says that your expenses on necessities should not be more than 50 percent of take-home pay. The next 20 percent of the budget goes to financial priorities, which are your financial goals  such as retirement contributions, long-term investments and debt payment if any that are essential to build a strong financial foundation. The remaining 30 percent bucket is to satisfy lifestyle choices, which are discretionary and often fun choices about how you set your standard of living. Though the flexibility of the 50-30-20 rules makes it easily adaptable to real life situations, this rule is the inability of people to figure out difference between needs and wants.

Emergency Funding Rule

Financial emergencies can come in the form of a job loss, significant medical expenses, home or car repairs or something that may result into shock and unplanned expenses. This necessitates creation of an appropriate emergency fund to set aside money available to cover surprise spending and income disruption, without altering the current household standard of living and without disturbing of your current ongoing investments. The emergency fund rule reckons to follow the 3-6-9 Rule for creating e-fund. The 3-6-9 Rule tell us how much money you should put aside to meet emergencies of life. It should not be some arbitrary number but depend on factors such as source and stability of income, number of earning members, willingness to adjust expenses during emergencies etc. The 3-6-9 rule suggests three months living expenses to multiple earners family, six months to single earner family and nine months to retirees and people with variable or erratic source of earnings. For the sake of liquidity, it should be kept in the form liquid assets such as cash, saving account, flexi-deposit or money market mutual funds so as to get quickly convertible into cash needed during the emergences.   Also Read: How to get prepared for Emergency Fund?

Money Borrowing Rule

In current scenario, we raise debt to buy a home, a car and even personal gadgets such as smart phone, Laptop, LED TV etc. For debt to purchase a house is somewhat good as  it is used to build an asset but other debt such as car loans and credit cards, if not managed well, leads to vulnerability to financial distress. The 28/36 Rule for borrowers provides you a useful starting point to calculate reasonable debt load. The rule envisages that households should not spend more than 28 percent of your gross income on mortgage payments, home insurance and property taxes and the maximum of 36 percent on total debt service that is housing expenses plus other debt such as car loans and credit cards.

The 4 Per cent Rule

The four percent Rule helps retirees determine how much money they can withdraw from their retirement corpus each year so as to exhaust their accumulated retirement corpus up to their life expectancy. For example, if you want to withdraw Rs 4 lakh a year for living expense, you would need to create a retirement corpus of Rs 1 crore to sustain withdrawal for next 25 years. But this rule does not take into account the inflation rate, interest rates, rising life expectancy or specific individual circumstances.

Effectiveness of the Rules of Thumb

In simple way, thumb rules can act as a good starting point to estimate the figure before getting into specifics. It is an easily learned and easily applied procedure for approximately calculating or recalling some value or for making some determination. On the other hand, overreliance on rules of thumb may lead to over simplification, and can diverge from the optimum solution fitting one’s financial situation.  While using of rules of thumb, one should not plunge into blindly that they are no solutions to all the ills, and need to be supplemented by thorough analysis and refined with considering an individual’s circumstances. Though the rules of thumb provide broad direction to you in understanding and effectively dealing with financial matters, but they must not be the only to rely on, as there is no substitute to actual planning. For complete wellbeing one needs to undertake an in-depth analysis and take a holistic view of any financial situation before taking a decision.

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