This blog post covers the basics of personal finance. I'm sure there are other blogs or websites that contain a plethora of information, but I wanted a few things to keep in mind for someone who wishes to start on the journey of personal finance. You can find a lot of information on how to grow our nest egg for retirement, but people forget that it is not the only thing out there. So before we get into details, lets start with the basics: What exactly is personal finance?
The way I see it, personal finance is, well, finance for self. Pretty self-explanatory, right? Like every company hires a CFO, every investment fund has a CIO, and every HNI has a wealth manager, similarly, every individual needs a financial guide. But most of them focus on growing wealth from an already established corpus. But before you can grow money, you need to save money. But we don't often know how much? And is that the only thing to do? Well, not quite.
There are milestones in every individual's life, like the first job, marriage, house, kids, etc. And at each milestone, one needs to reflect on his finances, and ensure he's doing the best he can to prepare (not just save) for the next milestone. Each milestone changes the objective, and before I complicate it further, how about we just look at the basic framework here, which can be applied to all of them? The way I see it, we can only do 3 things with money - save it, grow it, and protect it. But that's not all you can do, is there.
Step 0: Budgeting
The first step, or rather before you take the first step, you need to create a budget for yourself. And like a corporate P&L, create a similar P&L for yourself. The first item at the, the top is, of course, salary or income. Please remember to keep the post-tax income at the top, as that's all you can save or spend. Next you have expenses, which I like to divide in 2 parts - fixed and variable. Fixed expenses include expenses like Rent, Groceries, Gym, Maid Salary, Transportation, Utilities, etc. If one of those line items you think is variable, then, just take a ball-park figure like maximum or average (or 10-20% higher than average). At this stage, we're only looking to arrive at the ball-park figure of total fixed expenses,.
For the variable expenses, including all the things you like to do like movies, dinners, shopping, trips etc. Again, these expenses will vary month-to-month, or might not show up every month, but we're looking to assess how much we can or do spend. So take the average figure to arrive at the ballpark numbers for each, because we're again hoping the higher expenses in one month can be offset by the lower expense in the next. Or as I liked to do when I was young (and poor), I tried to offset one with another. So if I was taking a trip next month, I'd stop or reduce eating out to save money for that trip. Or I'd use public transportation more in a month so that I can shop a little more.
Step 1: Managing Expenses
Once you have your budget ready, you'll be able to solve the following equation.
Income (I) - (Fixed Expenses (FE) + Variable Expenses (VE)) = Saving (S), or
I = FE + VE + S
Since we have 4 variables above, out of which 2 are mostly given (Income & Fixed Expenses), the whole budgeting exercise becomes a balancing act between variable expenses and savings. And for an easier understanding, let's consider these variables in percentages with the income at 100. So the expenses, both fixed and variable, and the saving become a part of the pie.
Now there are multiple numbers thrown around on how to split this pie, and again depending on your income and other factors, it may change. But the most prevalent set of numbers are:
- Fixed Expenses: less than 50%
- Variable Expenses: less than 30%
- Savings: At least 20%
Again, these numbers are not set in stone. But I suggest one should try to limit his fixed expenses to under 50%. Since rent becomes a key number in that equation, I suggest it be kept up to 25% of Income. And if your rent is too high, you should ideally move. Similarly, limiting our variable expenses give us control over our saving rate. If eating out costs 1000 and your budget is 3000, then don't go out more than 3 times. Or look for cheaper places to eat. I know it isn't easy, because we don't always have that self-control, which makes it hard to follow the budget.
But there's another way we can take control, and that is by putting Savings ahead of Expenses. If you want to save 20%, then save it first and then spend whatever is left, instead of spending first and saving whatever's left. And by saving I mean not keeping it in the same savings bank account. Ideally, this money should be kept out of our reach, or at least difficult to reach.
Step 2: Saving and Investments
Once we know how much we to save, we need to know how to save. Again, most experts suggest one saving instrument (FD, mutual fund SIP, house), but this is where I disagree. I think we can further split this into 3 (or more) steps:
Step 2.1: Create a Safety Pot
One of the first things we should do is create a safety pot for an emergency. And no, giving birthday treats to friends is not an emergency. The ideal amount is 3-6 months' worth of expenses, but since we budgeted for 50% of salary under fixed expenses, I like to think an emergency corpus with 3 months' income should allow us to get by for 6 months. Since we want this money without delay and without any risk on principal, it is ideal to keep it in a fixed deposit (FD). To further reduce the risk of reinvestment and prepayment penalty, keep it under multiple FDs, like 3 FDs of 6-month tenure of equal amount maturing and rolling over every 2 months. You may give yourself a window to create this safety pot, or take it up in parallel with the other steps, but it should not be forgotten.
Step 2.2: Save tax with Investments
One of the best steps one can take is evaluate the tax saving options as the investment options. The 2 major categories for a salaried person to save tax are 80C (Rs. 1,50,000) and 80CCD(1B) (Rs. 50,000 under NPS). Under 80C, you can
- Do a 5 year FD with any bank. While the principal is safe and return guaranteed, the interest income is taxed. So with a higher marginal tax rate, the returns may not be as attractive.
- Do a Post Office or NSC FD. Similar to Bank FD, the interest income is again taxed here.
- Invest in a PPF plan. This enjoys a EEE (investment exempt - growth exempt - redemption exempt) status, and with a decent interest rate, sits pretty high among the choice of investments. The only caveat, is the amount is locked for 15 years, although you can redeem certain sum after 7 years.
- Invest in a ELSS Mutual Fund. This is an option I particularly liked, as the returns can be high, even double digit, the lock-in period is only 3 years, and you may not have to pay tax when you redeem. The downside is the principal is not protected, so if the market underperform, you may not only lose your return but your principal as well.
Step 2.3: Beyond Tax Saving Instruments
Once the tax-saving options are exhausted, it is important to look at the bigger picture. At an overall level, it is now pertinent to look at the asset allocation of the portfolio, and how much is currently in and going towards Equity and Debt. Typically, in a growth stage, I'd prefer to have 60% allocation to Equities and 40% to Debt. Since Equity investments are intended to be long term, Debt funds allow taking out money in the interim with minimal to no impact to portfolio returns. Also in case of a market downturn, some of the surplus from Debt funds can be moved to Equity to take advantage of the fallen prices. So set up SIPs for both Equity and Debt Mutual Funds when you do.
I prefer mutual funds are my first choice instrument as I have the option to invest in a variety of funds based on my risk (from liquid funds to small cap equity funds), but they are also tax efficient. How? In the case of a fixed deposit in the bank, you have to pay marginal tax on the interest income accrued, even though the income may not be in your hands. On the other hand, in case of a mutual fund, you only pay tax once you redeem. So if you don't redeem, you can keep deferring the tax liability. Also, if you can convert all gains to Long Term Capital Gain by holding onto your investment for more than 1 year for equity and 3 years for debt, then you pay even lesser tax (10% for equity and 20% (with indexation) for debt). And you can set up a SIP in any fund, and even invest in Direct Funds (which give higher returns owing to lower expense ratio). In case you're looking for top funds in category, Kotak Mahindra Bank curates their list of recommended funds available here and here.
If you feel you want to diversify further, you can invest in FD, Bonds, or even NPS. However, it is difficult to match the benefits of mutual funds unless you are looking for the absolute safety of principal or guaranteed returns.
Step 3: Insurance
With all the plans to saving and investing money, it is also important to look at protection for self and our dependents and family members. So while we're looking for investment, we should also look at insurance.
Insurance in India is divided into two categories - Life and Health, which are offered by separate companies.
Step 3.1: Life Insurance
Life Insurance is important to cover the risk of our loved ones, especially our parents. A suitable term life insurance policy covers the financial burden by not only providing a lump-sum amount in case of death but may also include regular monthly payments for a certain period. The annual premium is tax-deductible under 80C as well.
For the coverage, a good rule of thumb is look for at least 10-20 times the annual income. Depending on your age and lifestyle, you may get life insurance for 30-40 years for 0.1%-0.5% of the sum insured, payable annually. If you are married, then you can take a joint term insurance, which covers the risk of one person's death by paying the sum to the other while reducing the premium at the same time. The only problem I see regularly with insurance is mis-selling of ULIP policies as investment, even though they are costlier than separately buying life insurance and mutual fund.
Step 3.2: Health Insurance
Health Insurance is important, but since most employers provide health insurance as part of a corporate plan, it is usually not looked at by individuals unless their ageing parents needs are no longer covered by it. Policy bazaar allows you to compare life and health insurance policies, so whenever you decide to increase your sum insured, look for options and choose on the basis of not just premium but claim settlement ratio as well.
Summary
As a ready reckoner, we can keep the following steps in mind at the start of any financial planning process.
Step 0: Create a Budget of Income, Expenses (Fixed and Variable) and Savings
Step 1: Arrive at a Savings number by managing expenses
Step 2: Start savings journey by first creating a safety pot, exhausting tax saving options and set up SIPs
Step 3: Evaluate your insurance requirements
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