I got these personal finance ratios from an American Website and I do not know how it will work in India…but hey here it goes. But first the caveats..these ratios are for a common man. It will not work for a very low end person earning Rs. 50,000 a year or for a person earning Rs. 20,000,000 a year. Always true for ratios – to compare 2 companies or people, they have to be near each other. So a Lord Krishna bank cannot be compared to State bank of India.
Lets look at the ratios..
- Budgeting Ratio: 20-30-50 ratio. Says out of your Net take home salary, save 20%, the MAXIMUM that you spend on housing should be 30% and the balance 50% you spend on everything else. Which means if a person has a take home salary of Rs. 100,000 per month, he pays Rs. 30,000 as EMI / society charges / etc. and Rs. 50,000 on other expenses like food, clothing, vacation, etc. Sounds good? well I do not know what happens to a person earning say Rs. 20,000 per month. Will he be able to save Rs. 4000 in some form? He should spend only Rs. 6000 on rent (buying and EMI of 6k is almost impossible to think of), and spend on food, etc. only Rs. 10,000. Possible?
- 6X the monthly expenses is the Emergency Fund: If your monthly expenses are Rs. 40,000 and you are paying a car EMI of Rs. 8500 and a house EMI of Rs. 45,000, you need 93,500*6 = approximately Rs. 5,50,000.
- 10X of the annual expenses is the amount of Term Life Insurance that you need. Personally I do think this is too much of a simplification, but for the purpose of this article, we will accept it as it is.
- Limit Mortgage to 2.5X Your Income – Mortgage RatioThis is another ratio that’s built off a basic premise – you should spend less than 30% of your take home pay on housing. If you make Rs. 12,00,000 a year, this means your mortgage shouldn’t be greater than Rs. 30,00,000. If you put a 20% down payment, that’s a house worth Rs. 37,50,000. If you want more house, you need to come up with a bigger down payment.Why does this ratio work? Well it does not work in India. In India people commit to a much higher amount of loan, because the cost of housing in India is too high. So lets ignore it.
- 100 Minus Your Age – Investing RatioWhen you are building your investment portfolio, you need to do some asset allocation. There is no clear rule, however, one of the old rules is 100 minus your age should be invested in equities. These days as longevity increases, this 100 is being changed to 110, 120, etc.!! Americans claim that this ratio works very well.
If you’re 40, you should have 60% of your investment assets in shares and 40% in bonds. As you age, the allocation will shift from equities to bonds. If you feel that you’re a more risk TAKING person, you can use the 120 Minus Your Age ratio.
Why does this ratio work? It’s simple and it’ll STOP you from over thinking and worrying and start investing.
- Save 35X Your Retirement Year Expenses – Retirement Savings RatioHow much money do you need to save into a nest egg (retirement basket) to retire? Experts believe that a safe withdrawal rate in retirement is about 5% of your assets (the Americans think it is 4%). By withdrawing just 5% a year, it’s likely that you retirement funds will last as long as you do. Other way to look at it is to say that you will live till 90, and you have the corpus on the day you retire.
Why does this ratio work? It relies on the safe withdrawal rate of 5% and conservatively relies on your expense being the benchmark. The biggest challenge in retirement savings is getting people to INVEST smartly and target a REAL RETURN. With the 30X Your Current Expense a starting point and 100 Minus Age allocation rule for whellre to put your money, you eliminate guess work. As time goes by, you can make necessary changes.
- Age X Pretax Income / 10 – Net Worth RatioThis ratio comes from the bestselling book “The Millionaire Next Door.”
I DO NOT LIKE age as factor in any financial equation. A 25-year old medical student and 25-year old auto driver are on different income earning trajectories, and therefore, at the age of 25, the auto driver will have a higher net worth. He probably will have a higher net worth at 30 too, but from 45 onward the doctor and his higher earning power will outpace the auto driver! However, it is a good number to target, like the earlier ratios 1-6.
Why does this ratio work? Net worth is a very, very important metric to use, and the day you use this metric, you have arrived in the world of investing. This ratio works because it’s a reasonable target.
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