Young Indians who finish their education and start out in their careers hardly think about what to do with their income, other than repaying the education loan they may have taken for higher education.
This has given rise to a phenomenon of young professionals who have a high disposable income that gets disposed off by the end of the first half of the month. This can result in a lot of pain in latter stages of life when one is trying to catch up with investment opportunities that otherwise have been lost.
Here are some time-tested thumb rules that will help you plan your personal finances in a more comprehensive manner. Remember these are thumb rules and you can tweak them to meet your requirements, but if you do not have a plan in place this is the place you should start.
Income - Savings = Expenses
The first rule in personal finance is that you have to invest or save money before you decide on how much you can spend. A number of youngsters do not have any savings as they believe savings come from "surplus income". This is wrong. You first have to decide how much savings you need, and make them as soon as you receive your income. Now, plan your expenses with whatever is left.
How much you should Save?
At the start of your career you should be saving at least 10% of your post-tax income. As your income rises, the percentage of savings should increase, say to 15% in your early to late 20s to reach to 35% by the time you hit 40 years of age. Of course, the actual savings that you should make depends on your own life goals. These are just the bare minimum percentages to ensure you have a healthy stock of wealth.
While you can start by saving 10% of your post-tax income, you should be angling to follow the 50-20-30 rule. That is: Not more that 50% of your income should go towards living expense including household expenses, no less than 20% of your income should go into savings towards your short and long-term goals, and no more than 30% should be spent on avoidable expenses like outings, eating out and vacations.
How much you should Invest in Equity?
If you're not sure about how much of your savings should be in equity and how much in debt instruments, the most popular thumb rule is to decide this is the '100 minus' rule. That is, the percentage of your savings in the form of equity should be '100 minus your age'. For example, if you are 30 today - you should invest 70% of your total savings into equity. As you age, this percentage comes down as your risk appetite goes down with age and you should prefer the less volatile debt instruments.
Emergency Fund
While you should invest in insurance covers even when you are young, you should maintain an emergency fund that you can dip into if push comes to shove. This will come in handy in case of an emergency. Even when you are facing a tough time, you will not have to postpone unavoidable expenses and you will manage to honour your commitments towards EMIs etc. The rule of thumb is that the emergency fund should be equal to 9 months' worth of your total income. This will take time to build, your immediate goal should be to have an emergency fund equal to 3 months' worth of income at the earliest and build towards the ideal corpus.
Life Insurance Cover
As a rule of thumb, your life cover should be equal to 10 times your annual income. The most cost-effective way to achieve this is through a pure term insurance. This will give you a large cover at a low premium - as this does not involve any saving component. While you will get no returns on surviving the term, the risk to life will be covered sufficiently - and that should be the only reason to invest in a life cover.
How much to save for Retirement?
Most experts believe that your retirement corpus should be 30 times your annual income - to make room for inflation. As you can see this amount is based on your income and not the projected expenses post-retirement - and therefore could still be a disappointment. The best thing to do is to have a target in mind and work backwards to what you should be saving today. While money is fungible and has exactly the same value even when marked as "emergency fund" or "retirement fund" or "saving for goals" - separating them into these categories makes it easier to plan and execute towards your goals.
Getting a Car
Now that your savings have been planned, let us look at a few expenses that most young professionals have. Firstly, how much can you spend on a car? The rule of thumb for buying a vehicle is "20/4/10" - that is, you should make a down payment of at least 20% upfront, the financing you take for it should not be more than 4 years, and the monthly EMI towards the car loan should be less than 10% of your monthly income.
Getting a House
We all dream of owning a home. Again, you should pay 20% of the price as down payment. Total EMIs that you pay should not be over 50% of your income, and home loan EMI should be under 30% of the income. Given the current interest rates on home loan, the value of the house that you can afford comes to about 4.5 to 5 times your annual income.
Diversification
While a lot of investors tend to invest in as many as 25 mutual funds in the hope of diversifying their investments, this is not advisable. You should hold about 10 different funds - investing in any more spreads your funds too thin and only giving marginal benefits of diversification compared to loss in risk adjusted returns.
Net Worth
Thomas J. Stanley and William D. Danko in "The Millionaire Next Door: The Surprising Secrets of America's Wealthy" postulate that an Average Accumulator of Wealth has a net worth equal to product of their age and one-tenth of their pre-tax annual income. This should be the least net worth you should aim for. Remember that net worth includes not just your cash, investments and home equity but also tangible property like jewelry, furniture and other assets like books and paintings that you may own. So, if you are 30 and make Rs 14 lakh a year, your net worth should be at least Rs 42 lakh.
Remember that there is no generic solution to your personal finance situation. The thumb rules listed here are to be used as starting points - start here and tweak them based on your risk appetite, inherited wealth and personal goals.
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