Rules of thumb – What works and how?

Publication details: Money Manager – CNBC Bajar – 16-11-2015

Responses, opinion and view from Kartik Jhaveri.

While financial rules of thumb are easy to understand and provide a good starting point, they are not perfect substitutes for thorough analysis and customized financial planning. Therefore, one needs to be extra cautious while using them and not rely completely on them to make the right financial decisions. Here are some good rules of thumb to use.

1. What is the rule of thumb for wealth creation?

• Pay Yourself First. This wealth creation rule was coined by George S. Clayson in his eBook,’The Richest Man in Babylon’.
• This rules redefines the savings equation as “Income – Savings = Money available for spending” as opposed to the conventional view of “Income – actual Spending= Savings”.
• The standard rule is to save at least 10-20% of gross income every month.

2.  Is there is rule for managing emergencies?

• The 3-6-9-12 Rule
• This rule helps us create an e-fund (emergency fund).
• This rule tells us how much money should be kept aside to meet emergencies of life. i.e. 3 months living expenses for a family with multiple earning members, 6 months for a single earning member and 9-12 months for business owners.
• This is kept in the form of liquid assets such as cash, savings account and money market mutual funds which are easily converted to cash during emergencies.

3. The 20 second rule

• This rules prevents individuals from making frivolous or unnecessary purchases.
• While shopping pause for 20 Seconds and ask yourself – Do I really need this?

4. How to evaluate the merit of an investment

• Rule of 72- Double Your Money Rule
• It is used for making quick calculations and understanding the magic of compounding.
• This rule helps in estimating the approximate number of years it will take for an investment to double in value at the desired rate of return.
• Simply divide 72 with the rate of return. For example, at a fixed deposit of 9%, it will take 72/9 = 8 years for your money to double.

5. Life cover should be 10 – 12 times your annual income. How practical is this?

• This rule of thumb is often used to determine the life cover based on what an individual earns.
• Ideally add to this your loans and goals.

6. Moving on to Real Estate, is there some rule to follow?

• The ratio of real estate and other assets should be 1:2. Ideally for each rupee in real estate, you must have 2 outside it.
• This helps to maintain stability and liquidity.

7. How to know if you have enough wealth? Is there some rule for this?

• Yes – The “Minimum net worth rule”.
• This is Annual Expenses divided by FD rate multiplied by
  • 3 times if you are around 60.
  • 4 times if you are around 40.
  • 5 times if you are around 20.
  • Exclude your home and office from the net worth.

8. What about loans? How should one plan loans? 

• Home loan EMI – not more than  30 – 35% of monthly income.
• It is generally advised to contain home loan EMIs within 30 -35% of your monthly income.
• If it exceeds that level, restrict to 50% as the outer limit. This also depends on the banker and your income.
• If within limits, then other loans can take up the remaining space. All in all, loans should not exceed 50%, and in the worst case scenario 60%.
• This is based on the assumption that the remaining 40-50% is adequate for living expenses.

9. Some guidelines on home loan

• 1,000 rupee per lakh EMI rule
• Usually, when people avail home loans they are keen to find out the EMI.
• In such cases, we generally make use of this rule.It is often seen that the EMI turns out to be Rs. 1000 for a Rs. 1 lakh loan. So if you borrow a loan of Rs. 25 lakhs then your approximate EMI would be Rs. 25,000.

 

10. Something for senior citizens

• Keep everything liquid & use the 4-6% Rule.
• This rule helps retirees to determine how much money they can withdraw from their retirement corpus each year.