Proper financial planning is a crucial ingredient for achieving your long-term financial goals. Effective money management is not just about investing in the right assets but is also about knowing how much to allocate to each of them. In this article, we are going to look at a few of the most common budgeting rules that you must follow to become financially stable and independent.
Useful Budgeting Rules For Effective Financial Management
Budgeting rules are guidelines that can help you allocate your income efficiently and prevent financial mismanagement. Here are seven key personal finance rules that can help you dramatically transform your financial situation.
1. The 50-30-20 Rule
One of the most common, yet powerful money management rules is the 50-30-20 rule. It is a budgeting technique that requires you to allocate 50% of your income to your various needs, 30% for your wants, and 20% for savings and investments.
For instance, let us assume that your monthly in-hand income (post-tax) is Rs. 45,000. According to this rule, you would have to allocate your income in the following manner:
- Rs. 22,500 (50%) for meeting your needs like rent, utilities, and groceries.
- Rs. 13,500 (30%) for meeting your wants, which includes discretionary expenses.
- Rs. 9,000 (20%) for saving and investing.
Now, it is important to remember that this financial planning rule is just a guideline and that it can be adjusted according to your unique situation. For example, if you wish to accelerate your savings or investment rate, you could direct 30% of your income towards savings and investing and keep just 20% to satisfy your wants.
2. The Emergency Fund Rule
An emergency fund is very important for financial stability and independence. It acts as a financial buffer, protecting you from unexpected life events and expenses. The emergency fund rule suggests you have a backup fund that covers at least six months of your average monthly expenses. This way, you can prevent job losses, medical emergencies, or major repairs from draining your finances.
Assuming that your average monthly expenses are Rs. 36,000, you must aim to have at least Rs. 2,16,000 (Rs. 36,000 x 6) in your emergency fund. It is important to note that building an emergency fund often takes time. However, even small, consistent contributions can add up to a significant amount in just a few years.
Also Read More About Contingency Fund
3. The EMI Rule
The EMI rule, also known as the 40% EMI rule, is an important guideline for effective debt management. It states that your total monthly payments towards your debt obligations must not exceed 40% of your monthly income. The rule takes into account all loans such as mortgages, car loans, personal loans, and even credit card outstandings.
For example, if your monthly in-hand income (post-tax) is Rs. 45,000. Your total debt payments each month should not exceed Rs. 18,000 (Rs. 45,000 x 40%). If your monthly debt obligations exceed 40% of your income, your financial situation could quickly become unsustainable and may even lead you into a debt trap.
4. The Insurance Rule
One of the most important personal finance rules that you must follow is the insurance rule or the 20X insurance rule. It suggests that you must have a life insurance policy with a sum assured amount of at least 20 times your annual income. This rule of thumb helps ensure that your dependents are financially secure in the event of your untimely death.
For instance, if your average annual income is Rs. 6 lakh, your life insurance coverage must at least be Rs. 1.2 crores (Rs. 6 lakh x 20). While it may not be possible to secure such a high sum assured amount with regular life insurance policies, term insurance plans could potentially offer them.
Now, it is important to remember that this rule is only meant to provide you with a starting point. You may opt to increase your life insurance coverage depending on your specific financial circumstances, debts, future expenses, and number of dependents.
5. The Asset Allocation Rule
Choosing the right investment strategies is essential to ensure consistent wealth generation. If you are new to investing, the 100 minus age rule is a useful guideline for investment portfolio asset allocation. It states that the percentage of your investment portfolio invested in risky assets must not be more than 100 minus your age. The remainder of your investible funds can be spread across less risky and more stable investments.
For example, if you are a 26-year-old investor, you must not allocate more than 74% (100 – 26) of your capital to risky assets. Risky assets include equity stocks, high-yield bonds, and real estate, among others. The remaining 26% of your capital can be distributed across other low-risk investments.
This rule of thumb balances growth potential with risk management by encouraging you to gradually shift towards more conservative investments as you age. However, it does not take into consideration your risk profile, which is one of the major factors influencing asset allocation.
6. The Rule of 70
Understanding the power of money and the long-term impact of inflation is key to effective financial planning. The rule of 70 is one of the few personal finance rules that can help you in this regard. It is a simple, yet effective method to estimate just how long it would take for the value of money to go down by half. All you need to do is divide the figure 70 by the average inflation rate.
For example, if the average inflation rate is 5.5% per annum, then it would take approximately 12.72 years for the value of money to go down by half. Although this rule does not directly help you grow your wealth, it helps in understanding the long-term impact of inflation on your purchasing power and the importance of opting for investments that generate returns that outpace inflation.
7. The Rule of 25
One of the key budgeting rules for retirement planning is the rule of 25. It suggests you need to save at least 25 times your annual expenses before choosing to retire. For instance, if your annual expenses are Rs. 4.8 lakh, you must have at least Rs. 1.2 crore (Rs. 4.8 lakh x 25) as savings to retire comfortably. This particular rule helps you set a tangible and realistic retirement savings goal.
Conclusion
The various personal finance rules discussed above are designed to provide you with a comprehensive guideline framework for effective money management. As you have already seen, these rules are merely starting points and are not set in stone. You may choose to change them slightly to adapt to your unique financial situation, goals, and risk tolerance.
FAQs
Are personal finance rules applicable to all individuals irrespective of their income levels?
The financial planning rules are only meant to be general guidelines. Since each individual’s financial situation is unique, these rules may need adjustment depending on the income and expense levels.
Should I prioritise paying off debt or saving for retirement?
The choice between saving for retirement and paying off debt ultimately depends on which option provides the maximum benefit. For instance, if you have high-interest debt like credit card debt, it is advisable to pay it off before proceeding to save up for retirement. On the other hand, if you only have low-interest debt, you can consider focusing on saving up for retirement instead of reducing debt.
How to effectively implement personal finance rules?
Budgeting is crucial for the effective implementation of personal finance rules. It involves managing your income and expenses more effectively, which is crucial for meeting goals and obligations. Implementing budgeting rules can get challenging without proper budgeting.
How often should I review my budget?
Your budget must be reviewed as and when there is a major change in your financial goals or income and expense levels. Alternatively, you can also review your budget at regular intervals. These intervals can either be monthly, quarterly, or semi-annually.
How can I increase my income?
Some of the many measures you can implement to increase your income include switching jobs, freelancing, creating a passive income source, making use of tax benefits, and paying down debt.