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Sunday, March 10, 2013

8 Thumb Rules and Ratios you need for your personal budgeting

Making your personal finance work is important, and there are some rudimentary ratios and multipliers that give you a fair idea of where you stand with respect to your budgeting decisions at your home. Let us have a look at those.

1. Debt to Income Ratio
That denotes the percentage of income that goes into your debt repayment. Debt can be in terms of your mortgage EMIs or other personal or vehicle loans that you may be repaying.

Debt to Income Ratio = (Monthly Debt Repayment / Monthly Take home income) * 100

This ratio should not exceed 40% for mortgage based payments and 10% for other debts. Mortgage based payments can go up to 40% because the re-payment is building up a big asset for you.

2. Discretionary Spending
You may be living a frugal life for the sake of your financial freedom but everyday joy is a must. Life is only in the present - neither in past nor in future. At the same time, it is important to make the distinction between wants and needs and take prudent decisions for your and your families future.

Discretionary Spending should not exceed 15% of your net take home income.

3. Savings Ratio
This ratio shows how much of your income you should ideally save. The higher the ratio, the better it is.
Savings Ratio = (Your annual savings / Your annual income) * 100

When you are young and just starting off your career, the ratio can be as high as 40-50%. It gradually keeps coming down as liabilities go up in life, and it can go to as low as 10-15% in the age of 40 to 50 years.

4. Retirement Planning
This should be the most important financial goal for any investor. You can get a loan for anything today but for retirement.
At least 10% of your income should go for retirement kitty.

5. Contingency Ratio
This measures your ability to raise money during extraordinary circumstances such as a  medical emergency or a loss of job.
Contingency Ratio = Liquid Assets (e.g. FDs, Cash etc..excluding house, equity) / Monthly expenses.

One must have a contingency fund to take care of at least 5-6 months of household expenses.

6. Insurance Multiple
Adequate insurance risk cover is the bedrock of financial planning. Use this multiple to find out if you have sufficient cover.
Insurance multiple = (Life Insurance Cover - Outstanding loans) / Your annual income
It is advisable to have an insurance multiple of slightly above 6 to make sure you have adequate coverage.

7. Equity Exposure
Stocks / Equity have the potential to give you highest returns among all asset classes, but also carry the highest risk. Striking a risk-reward balance with age is necessary. Use this ratio to know how much you should invest in equities.

Equity Exposure = 100 - Your age.

If you are 25 years today, 75% of your portfolio should be in stocks. Risk should start coming down with growing age.

8. House Affordability Ratio
This ratio tells you whether it is a right decision to buy the house that you always wanted to buy or would that purchase likely to land you into a financial mess.

House Affordability Ratio = Price of house / Monthly income
If the ratio exceeds 60, then you are buying a house that you cannot afford. However, your final decision can depend on the assurance you have about the rise of your income in the coming years.

Use these ratios and thumb rules, just as a guideline. You need to innovate and explore more into the financial world. Things that work for everyone else may not work for you and vice versa. 

Cheers

Manoj Arora


2 comments:

  1. Hi Manoj,

    In my view, this the the best one so far. I liked it very much. Most of us do track these things, but putting it all in one page is excellent. Great job buddy. Keep it up.

    ReplyDelete