I have heard many a householder lament that by end of the month they do not know where their money has gone, and they are left with no savings and worse, waiting for the next salary credit. Do you fall in this category? This can happen if you do not keep household accounts. But while keeping accounts is a good habit, it will only help you to identify your items of expenditure, and does not help you keep a discipline on your expenses.
Is it necessary to keep a discipline on your expenditure? Absolutely! Since means are limited and wants are unlimited, you need to balance your income and expenditure and not give in to impulsive and unnecessary expenditure or those expenses that can be postponed. Many a family has used their credit cards indiscriminately and ultimately landed in a debt trap from which there is no escape. Horror stories of families committing group suicide because of the mountains of debt they have no hope of clearing in their lifetime frequently appear in the media. Unplanned large families, very low incomes, joblessness, sickness, litigation etc., are also some of the causes of debt. When debt is accumulated purely for consumption purposes or unplanned expenses, it has a habit of multiplying.
The answer to a disciplined financial life is financial planning. Financial planning requires budgeting and adhering to the expenditure budget and envisaging some savings for the future contingencies like children’s education, marriage, sickness, buying / constructing a home, vehicle repairs, retirement planning etc. First of all list out all your liabilities and assets and find out what is your net worth. If it is negative then it is a sign of looming bankruptcy! In the case of debt, your future income is also committed towards debt and it is all the more imperative that you start planning your finances. However if the debt is contracted for creating an asset (e.g., housing loan), the value of the asset may be more than the debt and thus balances out the debt to owned assets. If the debt is purely for consumption then you have a problem there. Debt to income ratio will give an indication of whether your debt is within your means. This is calculated by dividing your monthly debt repayment obligations by your monthly net income multiplied by 100. Consumption loans repayment should not exceed 10% and housing loan another 40%. Hence a debt to income ratio of 50% made up as above is considered as within tolerance limit. Beyond this, you are stretching it beyond your immediate means. However, this is only a thumb rule. In case you have many dependants, then debt-to-income ratio needs to be less than 50%. Or you may need to postpone the idea of buying a house till you have a better income flow.
What are the sources of income for an average middle class family? Salary, income from business or profession, interest and dividend income, pension, rentals, bonuses and incentives, annual increments are some of the usual sources of income. If the spouse is also employed, it helps in balancing your inflows and outflows.
Household budgeting need not be a very complicated affair. By use of excel spreadsheet you can attempt to start your financial planning. You need to plan month by month and then with cumulative totals arrive at your annual budget. One side of spreadsheet will show the inflows while another side the outflows and totals of inflows and outflows and the surplus or deficit. While doing so it is not possible to predict any large unplanned expenditure, and your budget will go for a toss when there is an outgo for such contingencies. That is why you need to set apart, say 5 to 10% of your income towards contingencies or a risk fund apart from expenses towards insurance premium on account of life, health, vehicle, house, accidents etc.
The deficits can be funded through credit card usage. But such credit card loans should not be rolled over more than one or two times, and needs to be paid off from surpluses in subsequent months. The reward points and cash backs if any will reduce your card funding costs to a very minimal extent. But it is a good idea to make use of billing cycle without resorting to roll over.
Expenses can be broadly categorized as fixed expenses, variable expenses and semi variable expenses. While fixed expenses can not be curtailed, the variable expenses come under the category of discretionary spending and you do have some control over it. The semi variable expenses are those which are recurring but you can curtail them by conserving the usage. Let us try to put the expenses in to various buckets before we start our budgeting exercise.
Fixed expenses are those that can not be tinkered with and which may not vary during the month. The typical items under this head can be: house rent, EMI on housing loan, insurance premiums, maintenance expenses of apartment complexes, children’s school fees and transport charges, newspaper charges etc.
Semi variable expenses are those that recur every month but by careful planning it can be controlled. Let us take electricity bill. You can curtail use of electricity without sacrificing essential comfort by using low power consuming lighting, switching off lights, fans, TV when not in use, sparse use of high power consuming household gadgets like geyser etc.
Variable expenses are those on which you have major control. To give an example, it may not be imperative to consume meat every day. You can substitute it with vegetable proteins like cereals and tofu etc. or cheaper meat products and try to reduce expenditure. Impulsive buying of clothes and accessories is a strict no! No splurging without any justification like occasional birthdays and anniversaries. I am not advocating that you live like a monk. I am drawing your attention to the old adage: Do not stretch your legs beyond the length of your bed!
Planning exercise need to commence from the day you start earning. This way before you start raising a family and adding dependants, you start the habit of saving. Savings rates will be higher when you are young and starts dropping as you age, because future earnings get impacted by debt and outgoes on account of housing loan, vehicle loan, personal loans, insurance premiums etc. When you are young, saving ratio should be 30 to 40% and can drop to 10 to 15% as you grow older. So, how to arrive at the savings ratio? Your annual savings divided by your annual income multiplied by 100 will give your annual savings ratio. Annual savings include statutory deductions like EPF etc as they are your compulsory retirement fund. Voluntary PF, PPF can be an addition to statutory savings.
Additional savings need to be invested in asset class like equity, debt, gold, real estate etc with the right mixture of liquidity and return. Instead of directly investing in equity, debt and gold, one can invest in mutual funds and ETF. Real estate investments over and above one dwelling house can be in units of REIT once it is fully operational.
Lastly, remember the old adage “A penny saved is a penny earned”. Wish you and your family a successful and well planned financial future!