Wednesday, January 16, 2013

Thumb Rules for Financial Planning :

Everyone has a unique situation, and there are no concrete financial numbers that define success, but there are some rules of thumb that can help you gauge your progress. While following these rules wont guarantee success, they will put you on the right track.

What should be my asset allocation or how much equity should I have?

This is the most common rule of thumb which is used in investment world. Rule says Equity percentage in your portfolio should be equal to 100 minus your age or in other words debt should be equal to your age. For eg if you are 30 you should have 30% of your investments in debt & 70% (100 – your age) in equity. This doesnot take care of risk appetite, risk tolerance or how far your goals are.

How much emergency fund I should have?

Emergency Fund helps people in case of sudden loss of income, medical emergency etc. Thumb rule says one should have emergency fund equal to 3 to 6 months of monthly expenses. You can keep it at 3 month if you are a government servant but in case of private job or profession you should keep it on the higher side of the range. Make sure you don’t use this amount for day to day needs/wants. For retired person emergency fund should be equal to 1 year of expense.

How much money will I need in retirement or how much corpus I should build?

You should have 20 times your income saved for retirement and plan to replace 80 percent of pre-retirement income. But here retirement means a retirement at age of 60 & life expectancy of 80 – and a conservative lifestyle. Essentially the formula is:

Financial Independence = annual income requirement X 20

The formula is based on two centuries worth of returns in the stock market and the real rate of return (5% annually) you can expect to earn after taxes, expenses and inflation.

If you have 20 times your annual income requirement, it means that with the prescribed withdrawal rate of 5% yearly from your nest egg and the annual expected net return on your investments of 5%, you will never run out of money. But now things have changed & you would have dream/planned lot of things for retirement.

How much I need to invest every month to achieve retirement goal?

Pay Yourself First: Aim to set aside at least 10% of your take-home pay
Paying yourself first is the most important bill you will pay each month.

The best way to implement this rule is to make it automatic. Have 10% of your take-home pay pulled from your paycheck and deposited into a separate bank account or in money manager fund.

If you already have a well-funded emergency fund and your short-term goals have been funded, you might funnel all of the ten percent into a retirement plan. Of course if you set aside 10% in your retirement plan, you will be contributing pre-tax which works out to be more than 10% after-tax.

If you have just started to work & would like to have a very simple lifestyle & retirement at age of 60 you can do it with saving 10% of your income. If you are planning for an early retirement start with 20% savings. Other rule says if you are in early 30s Save 10% for basics, 15% for comfort, and 20% to escape. If you are late by decade add 5% more in each category.

How much insurance should I have?

Here insurance means insurance. Rule says one should have sum assured of 8-10 times of his yearly income. I think this rule is far from perfect but still can be used as starting point. This does not take care of any of your goals, liabilities & even complete expenses.

Some planners suggest even more than five to eight times your annual income as the level of coverage you should carry. My suggestion is that you get your financial house in order, which means getting your net worth and cash flow statement together, and go talk to a financial planner, ask them how they are compensated to keep them honest with the advice they are giving you.

Please note that this factor or rule of thumb could be much higher, depending on the number of years of income you will have to replace. The highest factor I have seen is to multiply your annual after-tax income by 20.If you were to die and wanted to make sure your dependents would continue to receive exactly what you brought home each month, they would need to completely replace your income forever. According to the Twenty Factor Model, having an insurance policy with at least 20 times your annual income will do.

The Short-Term Debt Rule of Thumb:

So-called Bad Debt should not equal more than 20% of your income

Short-term debt includes your car and student loans, as well as your credit cards and other forms of debt. Essentially everything except for your mortgage. You need to list all your outstanding liabilities and their respective minimum/monthly payments. Now add up the minimum/monthly payment amounts and you come up with a figure.

Take this number and divide it into your monthly take-home pay.

If the result is more than 20%, you are carrying too much revolving debt. New entrants to the workforce or recent graduates often have a higher debt-to-income ratio because of their student loans and entry-level jobs that pay low salaries.

Compulsive spenders also have a problem because they spend every rupees they make.

You should aim to put at least 20% of your net pay toward paying down your outstanding debts. If you cease to add to your short-term debts today, you will find that you can pay off most of your short-term debt anywhere from 3-7 years.

How big should be my House?

The value of house should be equal to 2-3 times of your family annual income. So if you & your spouse are earning total Rs 20 lakh – you should buy a house in Range of Rs 40-60 Lakh.

Maximum EMI that I can have?

Ideally 0 will be the best answer but few of the big assets like home require some loan to buy them. Experts agree that your EMI should not be more than 36% of Gross Monthly Income at any point of time. It should be even lesser when you are close to your retirement. If you want to talk about home loan EMI, it should not be greater than 28% of your gross income.

Why 36%?

Well, banks like to see that the cost of your monthly mortgage payment, taxes, insurance, and utilities will not place an undue burden on your finances.

In short, they calculate the cost of living in your home and know that if you are exceeding 36% for your housing costs, you have probably bitten off more than you can chew.

Regardless of what your current percentages are, aim to reduce these percentages over time. Just because a bank is willing to lend you up to 28 percent of your gross monthly income, it doesnot mean that you should borrow that much money to buy a house.

The less money you borrow, the faster you can pay it back and the higher your monthly cash flow will be (because you are spending less on your mortgage). The less you spend monthly, the more you will have to invest for your future.

Rules of thumb for buying a car

This is one of the biggest purchases after your home. And this is depreciating asset – today morning you purchase a car for Rs 10 lakh & by the evening it will be worth Rs 8-9 Lakh. After 5 years it will not be even of half value but still you keep buying cars regularly – buy at 10, sell at 4 & loose 6. (repeat the cycle) There are few rules that you can follow:

Value of car should not be more than 50% of the annual income of the owner.

Purchase a used car or buy a new & use it for 10 years.

While buying car with loan stick to 20/4/10 – Minimum 20% down payment, loan tenure not more than 4 years & EMI should not be higher than 10% of your income.

Rate of return Rules of Thumb

In how many years my amount will double?

Its a very simple & most common rule – if you divide 72 by rate of return you will get the number of years in which your money will double. For Eg. If you expect a rate of return of 12% you money will double in 6 years (72/12=6) & what about if rate of return is 8% – 72/8=9 years. This can also be used in reverse order at what rate your money will double in 5 years – 72/5=14.4%

Rules similar to rule of 72:

Rule of 114 & 144

These can help you in how many years your money will be triple (114) or quadruple (144) at some rate of returns.

Rule of 70

You know it or not but inflation is your biggest enemy – rule of 70 will tell you in how many years value of money will be half. You just need to divide 70 with rate of inflation so if rate of inflation is 7% – 70/7=10 years. So in 10 years your Rs 100 note will be worth Rs 50.

Rule 10/5/3

This is a US rule of thumb which says in long term you can get 10% return from equity, 5% return from bonds (let’s say FDs) & 3% from the t-bills (liquid funds – these returns are more or less close to the range of inflation). Indian economy is growing at some different pace & even inflation numbers are different. Can we safely say if inflation is 6% (t-bill rates) we can get 8% from the fixed deposits & 12% from the equity or in other words – in long term equities will deliver twice the return of inflation. Try combining Rule of 72 with this rule – you will get some amazing numbers.

The Charity Rule of Thumb:

Give away at least 10% of your net pay every month.

Most of us think that there is not enough money to go around. We live in a state of scarcity instead of a state of abundance. We think that if we give away ten percent of our income each year, we cant possibly make ends meet or be able to afford a decent retirement.

I understand the fears, but if you put all the previous rules of thumb in place, you should not have to worry too much about making ends meet.

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