Thumb Rules
Thumb rules provide a fine starting point or a reference on which you can build your final decisions.
However, for precise decisions it is important to do further research or approach a financial advisor for personalized guidance and advice. While using these thumb rules, the user must also try to understand the rationale or assumptions behind each rule. Blindly following the thumb rules may be injurious to your financial health. As Buffet put it brilliantly “Too often, though, investors forget to examine the assumptions behind the models.”
Here, we shall discuss 5 popular personal finance thumb rules;
Savings
The key to build wealth for your future is to save 30% of your income. You can read that as at least30% (keep this highlighted) of your income.
Emergency Fund
You would know the importance of creating an emergency fund. The idea is to keep 3-6 months of your total monthly expenses in the emergency fund. This should be regular expenses, EMIs and insurance premiums. The 3 months time period is for those who have a secure job like a government job. For those in a private job, an emergency fund, worth at least 6 months’ expenses is recommended. Whereas for those who are self employed, an emergency fund worth 12 months’ expenses should be kept aside. An emergency fund is not aimed at meeting your planned goals, but it only acts as a safety net.
Investments
After an emergency fund is created, whatever remains should be invested to build wealth for a longer term.
When investing, it is advisable to divide one’s investments into debt and equity. This thumb rule suggests that the percentage of equity in your portfolio should be 100 minus your age. So when you are 30, the equity portion of your portfolio should be 70 per cent. This thumb rule is based on the fact that equity investments deliver good returns over a longer time period as market volatilities even out. So when you have a long term investment horizon you should invest more in equities and decrease it as you near your goal. However this rule is flexible and depends on one’s risk appetite. At 30, one may have 90 or even 100 per cent of one’s investments in equity. One may move up to 90 per cent to debt by the time one is a couple of years away from retirement.
| Age |
Equity |
Debt |
| 25 | 75% | 25% |
| 30 | 70% | 30% |
| 35 | 65% | 35% |
| 40 | 60% | 40% |
| 45 | 55% | 45% |
| 50 | 50% | 50% |
| 55 | 45% | 55% |
| 60 | 40% | 60% |
EMIs
The thumb rule states that EMIs as a percentage of your income should not exceed 35-40 per cent. Anything above that might strain your finances. So, if your monthly income is Rs 1 lakh, your total EMI outgo for loans should not be more than 40 per cent. It is better if it is lesser, but you should not cross this limit. This one is a thumb rule that pretty much applies to everyone.
As a rule of thumb I would say not exceeding 40% of your monthly income assuming this includes home loan EMIs. In an ideal scenario zero EMI would be a better option. Today it’s important to use some financing or debt in a moderate fashion to achieve your goals or to meet certain needs.
For instance a housing loan, educational loan or credit cards are part of life. Even personal loans, car loans, etc are good options provided they are used wisely without stretching to the last penny.
Even banks check for this aspect when they underwrite loans. For instance in case of home loans the bank would ensure that the total EMI does not exceed 50% of your monthly income.
Retirement Planning
How much do you need every month after you retire? The thumb rule says 80 per cent of your current total expenses. This assumes that certain expenses reduce after retirement. This may include the daily transport expenses. Or the children may move out. However there are two things to take note of in this case. Nowadays people prefer to travel and pursue hobbies after they retire. So, one may need more income than the thumb rule prescribes.
Also, this is for calculating the present value of money required. One needs to factor in the inflation. Let us suppose you are 25 years from retirement. You have figured out that you require Rs 60,000 every month in retirement. The money you would require about Rs 3.25 lakh in the first month after you retire at an inflation of 7 per cent. One thing to remember is,an early start lets you maximize the benefits of compounding.
Insurance
No matter what you’re financial situation, insuring against the unexpected can help keep you on the right track should accidents create a financial burden. Insurance has to be accident proof and not investment oriented.
- Life Insurance
You are not the beneficiary when you buy life insurance. So you don’t need a life insurance if you don’t have any dependants.Only the earning member of the family should have a life insurance. You should ideally have a cover which is at least 20 times of your annual income, along with a critical illness rider.
- Health Insurance
A medical emergency is not only heavy on the pocket, but it can also derail your long-term financial plans. Buy a health insurance plan for yourself and all the members of your family overand above what your employer firm provides.
Every member should have a minimum cover of atleast 2-3 lakhs.
Go for policies that have a large network of hospitals with cashless coverage.
Getting a life insurance might be optional based on whether you have dependents or not but a health insurance today is pretty much non-negotiable.
The above rule is the starting point that defines the bare minimum. This is still shown as a range because a one-size fit all approach doesn’t work.
Gold
Ideal allocation to gold is around 10% of your financial portfolio. The financial portfolio includes Bank Balance, Fixed Deposits, Post Office Schemes, Mutual Funds, Bonds, Shares, and Stocks etc. Accordingly, if your financial portfolio (without adding the value of your house) is Rs.1 crore, then your maximum exposure to gold including Gold Mutual Fund or Gold ETF should be Rs.10 lakhs. If your investment in gold is less than 10% of your financial portfolio, you may invest in Gold ETF or Gold Mutual Funds rather than buying physical gold which carries the risk of being stolen. On the other hand, if your current investment in gold is higher than 10% of your financial portfolio, then at least do not make any fresh investment in gold until your financial portfolio grows and your exposure to gold comes down to around 10%.
20% down payment rule
This thumb rule basically applies to the minimum down payment a borrower should pay from own funds while taking any form of loan liability (Housing loan / Car loan / any other loan).
The rationale for the rule is twofold. First and foremost the 20% down payment is barometer to infer whether the borrower is stretching beyond means or well within his affordable limits. Secondly, higher the down payment, lower will be the interest liability for the borrower.
28% Housing EMI rule
This rule talks of the maximum amount one can budget for housing loan monthly EMI payments.
Everyone loves to own a big house from a reputed builder in a posh locality. The tax rebates on housing loan payments gives further incentives to a prospective home buyer to go for bigger houses. This rules helps us with a reality check.
Rule
Maximum Monthly Home loan EMI = 28% of Gross monthly income
Example
If you make 1 lac (1,00,000) a month then your monthly home loan EMI should not exceed 28,000.
20/4/10 Vehicle rule
This rule talks about the prudent practices while purchasing a vehicle / car by way of a loan.
Rule
The rule states that you should make a down payment for the loan of at least 20% of the on road price; the tenure of the vehicle loan should not be more than 4 years; the total expenses towards the car ownership should be less than 10% of gross annual income (total expenses ideally should include vehicle loan EMI expenses + fuel expenses + insurance + any other vehicle expenses like parking rentals )
Example
Let us say your annual income is 20 lacs (20,00,000). This rule states that your yearly transportation costs (car loan EMI + annual fuel expenses + annual insurance) should be less than 2 lacs.
50% Car rule
This rule talks about the maximum price we can budget for purchase of a new car.
Rule
Car affordability = 50% of Gross annual income
Example
If you are making 20 lacs per year (gross) then you can plan for a car worth 10 lacs. In this case if you wish to go for a new Audi Q7 worth 70 lacs then clearly you are stretching beyond your affordable range.
10 year Car rule
This rule states that to be financially prudent one needs to use a new car for at least 10 years. Car is one thing which depreciates quickly. The value of a car falls minimum 15% the moment it hits the road and is out of the showroom.10 years of vehicle ownership is considered ideal to get maximum value of your vehicle purchase taking into consideration the effects of depreciation as well as possible spiraling of maintenance expenses of older vehicles.