Benjamin Franklin famously said, “An investment in knowledge yields the greatest return.” It emphasizes the importance of gaining knowledge before starting anything, be it investing or anything else. So, if you are looking to start your investment journey in 2024, you need to understand some personal financial ratios and rules. Let's discuss them.
Before you start investing, you need to save money. Your savings rate measures the percentage of your income that you save. It is calculated as follows.
Savings rate = Savings / Total income
Suppose your monthly income is Rs. You can save Rs 50,000. 10,000. In this case, your savings rate would be 20%, which is a good ratio to start with. The higher your savings rate, the better because it allows you to put more money toward investments that will help you reach your financial goals.
You can use the 50/30/20 budgeting method, which allocates 20% of your monthly income to savings and investments. Once you get used to this method of budgeting, you can aim to increase your savings rate beyond 20%. Allocating more money toward your financial goals will help you reach them faster and achieve financial freedom.
Action points for 2024: Start by aiming for a savings rate of 20%, and increase your savings rate further over time.
Many people have loans, such as home loans, car loans, education loans, personal loans, and credit card balances. Some people have multiple loans running at the same time. Debt-to-income (DTI) ratio measures the percentage of your income that goes toward paying loan EMIs. It is calculated as follows.
DTI = Monthly Debt Repayments / Monthly Income
Suppose your monthly income is Rs. 50,000 then you pay Rs. 15,000 towards loan EMI. In this case, the DTI ratio would be 30%. The lower the DTI, the better. Ideally, the DTI ratio should be 30% or less.
If your DTI ratio exceeds 30%, it can put a strain on your overall household finances as you have to manage monthly expenses, savings and investments in addition to loan EMIs. Lenders like banks and NBFCs look at your DTI ratio while approving a loan. His DTI ratio of 30% or less is considered favorable to lenders. Some lenders may consider DTI ratios between 30% and 40%. If your DTI ratio exceeds 40%, it will be difficult to obtain a loan.
You can improve your DTI ratio by prepaying your existing debt. This can be done using surplus funds. Before you can start investing, you'll need to pay off any large debts, such as credit card balances or personal loans. As your income increases over time, use the increased cash flow to prepay your loan and lower your DTI ratio.
Action points for 2024: If a higher percentage of your income goes toward loan repayments, aim to lower your DTI ratio to 30% first. Take steps to reduce it further over a period of time.
Measures whether an individual can pay off all debts with accumulated assets. It is calculated as follows.
Solvency ratio = total assets / total liabilities
Ideally, this ratio should be greater than 1. A ratio greater than 1 indicates that the amount of assets is greater than liabilities. The higher the ratio, the better. A ratio of less than 1 indicates that you have more debt than assets, which is not a good situation. In such a scenario, you should focus on reducing debt, increasing assets, or a combination of both.
Action points for 2024: Calculate solvency ratios. If it's less than 1, work towards getting closer to 1 and improve further over time.
6X emergency rules
Life is uncertain because unexpected or unplanned financial emergencies can occur. Therefore, you should have an emergency fund on hand to deal with such situations. According to the 6X emergency rule, you should have an emergency fund equal to six months' worth of expenses. Some personal finance experts refer to this as the “3X emergency rule.” This means that the emergency fund should be equivalent to three months of his expenses.
If you're a salaried employee with a stable job at a company that is doing well financially, a 3x or 6x emergency fund may be enough. However, self-employed people and business people with uneven monthly cash flow may need to maintain a larger emergency fund. This could equate to his 9 or 12 months worth of expenses.
Action points for 2024: If you don't have an emergency fund, start building one right away. If you have an emergency fund, make sure the amount is appropriate for your situation.
100 – Age Stock Investment Rules
Over the long term, stocks have provided high returns that outpace inflation, creating wealth for investors. Therefore, investors should allocate to equity mutual funds. Personal finance experts recommend stock allocation as follows:
Stock allocation = 100 – age
Suppose your age is 25 years old. As per the above rules, equity exposure should be 75%. While this is a general rule and can be used as a starting point, there are better ways to determine stock allocation. Besides age, other factors that determine your stock allocation include your risk profile, time left to reach your financial goals, and financial debt.
Action points for 2024: Decide on stock allocation considering your age and other factors and start investing in stock investment trusts through the SIP route.
10x life insurance rule
A life insurance plan provides financial backup for your family in case you suddenly pass away. Personal finance experts recommend the “10x life insurance rule,'' which increases the amount of life insurance coverage by 10 times your annual income. Some experts recommend the 20x life insurance rule, which suggests that the amount covered should be 20 times your annual income.
While this is a good starting point, there are better ways to determine your personal life insurance coverage requirements. When calculating the amount of life insurance coverage, you need to consider your future income, financial goals, loans, and family expenses.
Action points for 2024: If you haven't already done so, purchase a term life insurance plan. If you have life insurance, evaluate whether the coverage is adequate. If not, get additional life insurance.
The start of 2024 is a great time to understand the basics of personal finance rules and ratios. A proper understanding of these personal financial rules and ratios will establish a strong foundation. A strong foundation will help you create a smooth financial plan.
Gopal Gidwani is a freelance personal finance content writer with over 15 years of experience. You can contact him at: LinkedIn.
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