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Basics of Personal Finance
Rohan, 28, has been planning to buy a new house for the last five years. He invested lacs of rupees monthly into stock markets, hoping for quick returns. Despite not having enough experience and expertise, Rishi, his friend, recommended several stocks to him. However, the market crashed, and his savings weren’t enough to buy the dream house. Now he may have to wait slightly longer to recover his losses until the next bull run, delaying his purchase.
What do you think went wrong here? Let’s try to analyze Rohan’s situation:
1. If Rohan had approached an RIA/MFD, he could’ve ensured effective risk management. Wealth-building needs expert guidance and discipline.
2. Rohan should’ve shown responsible financial behavior to avoid losing such a huge amount of money. It’s crucial to understand the basics of personal finance.
We all indulge in money management activities daily. From banking and insurance to taxes, investments, and mortgages, we handle a mix of financial activities. This is called personal finance. Budgeting is the answer when there’s a question of wealth-building and personal finance. Through this article, we aim to walk you through the meaning, importance, and methods of budgeting in personal finance and money management.
Budgeting in personal finance
Budget is the availability of funds to buy something, right? Not really. In budgeting, you estimate your expenses as well as your income. For instance, let’s say you earn ₹1,50,000 per month and have ₹4,50,000 as savings. You wish to purchase gold jewelry for your sister, which is worth ₹5,00,000, despite having EMIs worth ₹35,000.
While you’ll still have ₹65,000 left in your bank account. But –
● Is that enough for your routine expenses?
● What about unexpected expenses?
● How will you manage other investments for financial goals?
Assessing such financial aspects is a vital part of budgeting.
Money management technique
Remember – it’s not about the funds you have. It’s about the funds you should have after spending your money. Here are a few positive outcomes of having a step-wise money management technique in place.
You already have five credit cards and have got two more bank offers. Imagine dealing with your existing bills while you just planned five more expenses! This is where budgeting comes into the picture. A budget keeps you aware of what you can afford and how to avoid unnecessary debts.
You must know that spending money is easier than saving it. Whenever you wish to purchase things that make your life easier, ask yourself two questions – is it the need of the hour or can it be delayed further without impacting your current situation? This is where budgeting plays a major role in bridging the gap between your necessity and desire. How can you achieve this?
Planning for your dream goals
There’s something more important than managing your current finances; it is saving for the future. A good budget in place helps you manage your current finances and plan for your dream goals. But why should you care about the future when you prefer living in the present? This sounds fascinating until you need to start saving money for your –
● Next car
● New house
● Kids’ higher education
● Insurance premiums
● Business aspirations
● Investment goals
● Lifestyle expenses
A budget helps you stay disciplined even when you have money to buy almost everything.
#Example: If you wish to buy a car that costs around Rs. 8 to 9 lacs and you shortlisted a good model that costs you Rs. 6 to 7 lacs, you get to save Rs. 1 to 2 lacs on that purchase. You can think about investing the differential amount in equity mutual funds, sovereign bonds, liquid mutual funds, and steadily increase your wealth over the next 10 to 15 years.
Once your investment portfolio grows, you can think of buying a luxury product or a car of a higher value to gratify your need.
It is how instant vs. delayed gratification works.
Budgeting is all about compounding your income for better financial security in the future and, of course, greater savings. It helps you plan and manage your current finances and gives you freedom to invest in different financial instruments that can help you attain long-term financial freedom.
Maintaining emergency funds
Creating an emergency fund means maintaining at least six to twelve times your mandatory monthly expenses on hand. The key is managing existing financial liabilities while preparing for variable spending.
This is where budgeting gets serious, and you should be too. It can take care of everything from medical expenses to financial setbacks.
#Example: Meenakshi’s 80% of income goes into monthly expenses (like EMIs, household expenses, groceries, medicines, etc.) while she saves 20%. While she has been an active trader, her current trades have not reaped her the desired outcome. The market has been fluctuating and she has been experiencing a significant drop in valuation in the stock market.
None of her finances go towards safe investments like debt mutual funds, FD, or sovereign gold bonds. Unfortunately, her dad, 65, suffers a heart attack and needs surgery worth five times what Meenakshi earns each month.
● What will Meenakshi do now?
● Does she have any emergency funds?
● If she takes a personal loan, how will she repay it?
● Do you think she can manage this situation without a mishap?
Precaution is always better than cure.
Here’s what Meenakshi should have done:
● Invest in equity and debt mutual funds under the guidance of an MFD/RIA for creating contingency funds and working towards goal-based investing.
● Ensure consistent investments every month to increase her financial assets.
Your savings and investments will aid you whenever you urgently need funds. Emergency funds for at least six to twelve months can easily help you deal with any unaccounted expenses without worrying about financial troubles.
This is possible only if you patiently follow a budgeting rule of thumb with discipline and planning.
While you have understood how to create emergency funds and plan your financial goals, you still need to understand the underlying concept of creating a budget.
Creating a budget
There are several ways to plan your personal finance; however, the 50/30/20 rule of thumb is an ideal way to begin planning your budget and increase your savings as you grow.
#Example: If Karan earns ₹1,00,000 a month, he should dedicate 50% of that towards his immediate needs. It may include house rent, EMIs, kids’ fees, insurance premiums, and household expenses, to name a few. The rest of the 30% (₹30,000) should be Karan’s funds for fulfilling his wants. This may include lifestyle costs such as entertainment expenses, gym fees, kids’ toys, wife’s jewelry, and so on. The remaining 20% (₹20,000) of his income must go towards savings and investments. The 50/30/20 thumb rule revolves around your income, needs, wishes, and savings/investments. Your goal here is to maximize income allocation towards investments.
As a result, Karan can enjoy his financial freedom if he can do this consistently over the next 20 to 25+ years.
But how will you do this?
Calculate avoidable expenses and allocate certain portions towards your investments.
#Example: From Karan’s income of ₹1,00,000, he allocates ₹20,000 to his investments while spending ₹50,000 as mandatory expenses. Now, he’s left with ₹30,000 to spend anywhere he wants. Some of these funds are his avoidable expenses.
Though he has the liberty to spend all of it, he can still shell out a portion of those funds towards his savings and investment. And here’s how you can do it –
Income – investments – necessary expenses = avoidable expenses
After subtracting the necessary expenses and investments from your total income after tax, you’re left with limited funds.
Now, let’s see how the process of the 50/30/20 thumb rule works.
Sources and total income
Firstly, list all your income sources, including the return on investments for that period. Now, calculate the sum and deduct the taxes. The final number is your estimated cash flow from where your entire budgeting process begins.
Needs and mandatory expenses – 50%
Loan EMIs, house rent, and essential food items are the main examples of mandatory expenses. You need to pay for these as they require a high degree of necessity. You can start by allocating 50% of your income towards such expenses.
Wants and additional expenses – 30%
Next, you can take up to 30% of your income to spend wherever you want. These expenses are directly related to what you desire to buy but still can avoid. You can consider this as an ‘additional expenses’ category.
Savings and investments – 20%
Lastly, you can consider the remaining 20% of your income as the amount you have remaining to save. This amount can go to your investments. The key to a successful budget is minimizing the additional expenses to maximize your investments.
Remember – safe and fruitful investments mean better returns in the future. Ultimately, the returns will come to you as surplus savings. If you have just started earning, the ideal way to approach your savings is by allocating your income to financial products from the first month.
Sticking to the budget
A good budget is similar to great power; it brings a bigger responsibility. To help you plan your budget better, you can ask yourself-
● Why did you create a budget in the first place?
● What made you give importance to budgeting?
● If you follow the budget dedicatedly, what will you achieve?
All of these questions hint at your financial goals. Their answers will motivate you to stick to your budget.
● Manage risks effectively
● Categorize your expenses
● Create more room for savings
Impact of financial behaviors
Your financial behaviors influence arranging your budget, planning your monthly finances, and saving for your future.
#Example: Advait has been driving a Mercedes C-Class for 3 years. His friend, Pratik, is tempted by this and plans to buy one for himself.
After two days of introspection, Pratik realized he still had 4 years of home loan EMIs pending. He also thought of the savings he was planning to do for his sister’s marriage expenses.
He decided to wait for the next 5 years until he accumulated sufficient funds for his additional expenditures.
Now, this is what we know about Pratik:
● He showed financial awareness at the right time.
● This illustrated his discipline and patience towards his financial situation.
● He prioritized wealth creation over an impulsive purchase due to influence.
These are good financial behaviors. The central idea of managing your money and budgeting your monthly expenditure is to build wealth over time.
Managing your money is about patience and discipline, rather than greed, fear, or overconfidence.
With the help of RIAs or MFDs, you can start systematic financial planning that will allow you to create wealth over time. Contrarily, getting impatient or influenced by people around you with different financial standing may invite unnecessary monetary roadblocks.
Hence, good financial behavior is your stepping-stone towards sincere budgeting. As a result, you’ll master the basics of personal finance and unlock effective money management strategies.