A famous quote from Benjamin Franklin says: "An investment in knowledge pays the best interest". It highlights the importance of gaining knowledge before you start something, whether your investments or anything else. Hence, if you are beginning your investing journey in 2024, you must understand some personal finance ratios and rules. Let us discuss them.
Savings ratio
Before you start investing, you need to save money. The savings ratio measures the percentage of income you are saving. It is calculated as follows:
Savings Ratio = Savings / Gross Income
Suppose your monthly income is Rs. 50,000, and you are saving Rs. 10,000. In this case, your savings ratio will be 20%, which is a good ratio to start with. The higher the savings ratio, the better, as it helps you channel more money towards investments for fulfilling your financial goals.
You can use the 50/30/20 budgeting method that allocates 20% of the monthly income towards savings and investments. Once you get comfortable with this budgeting method, you can aim to increase the savings rate beyond 20%. As you allocate more money towards your financial goals, you will be able to achieve them faster and attain financial freedom.
Action point for 2024: Aim for a savings ratio of 20% to start with, and take steps to increase it further over a period of time.
Debt to income ratio
A lot of people have loans such as a home loan, vehicle loan, education loan, personal loan, credit card outstanding, etc. Some people have multiple loans running at the same time. The debt to income (DTI) ratio measures the percentage of income going towards paying loan EMIs. It is calculated as follows:
DTI = Monthly Debt Payment / Monthly Income
Suppose your monthly income is Rs. 50,000, and you pay Rs. 15,000 towards loan EMI(s). In this case, your DTI ratio will be 30%. The lower the DTI, the better. Ideally, the DTI ratio should be 30% or lower.
A DTI ratio of more than 30% can put pressure on your overall finances, as along with loan EMIs, you have to manage your monthly expenses and savings and investments. While approving loans, lenders such as banks and NBFCs look at your DTI ratio. A DTI ratio of 30% or lower is considered favourable by lenders. Some lenders may consider a DTI ratio between 30% and 40%. It is difficult to get a loan if the DTI ratio is above 40%.
DTI ratio can be improved by prepaying existing debt. You can do that by using your surplus funds. Before you start investing, you should pay high-cost debt such as credit card outstanding or personal loans. With time, as your income increases, use the higher cashflows to prepay loans and bring down the DTI ratio.
Action point for 2024: If a higher percentage of income is going towards servicing loans, aim to bring down the DTI ratio to 30% to start with. Take steps to decrease it further over a period of time.
Solvency ratio
It measures whether an individual will be able to repay all liabilities with the assets accumulated. It is calculated as follows:
Solvency ratio = Total assets / Total liabilities
Ideally, the ratio should be more than 1. A ratio of more than 1 indicates a higher amount of assets than liabilities. The higher the ratio, the better. A ratio of less than 1 indicates a higher amount of liabilities than assets, which is not a good position to be in. In such a scenario, you should focus on reducing your liabilities, increasing assets, or a combination of both.
Action point for 2024: Calculate your solvency ratio. If it is less than 1, work towards bringing it to 1 and then further improve it over a period of time.
6X emergency rule
Life is uncertain, as it can bring unexpected or unplanned financial emergencies. Hence, you should have an emergency fund handy to tackle such situations. As per the 6X emergency rule, you should have an emergency fund equivalent to 6 months of expenses. Some personal finance experts call it the 3X emergency rule, wherein the emergency fund should be equivalent to 3 months of expenses.
For a salaried individual with a stable job in a company doing well financially, a 3X or 6X emergency fund may suffice. However, a self-employed individual or a business person with uneven monthly cash flows may have to maintain a bigger emergency fund. It may be equivalent to 9 or 12 months of expenses.
Action point for 2024: Start building an emergency fund immediately if you don’t have one. If you have an emergency fund, check whether the amount is adequate depending on your situation.
100 – age equity investment rule
Equities have given inflation-beating high returns in the long run and created wealth for investors. Hence, investors should have an allocation to equity mutual funds. Personal finance experts recommend the equity allocation as follows:
Equity allocation = 100 – Age
Suppose your age is 25 years. As per the above rule, your equity exposure should be 75%. While this is a popular rule and can be used as a starting point, there are better ways of determining equity allocation. Apart from age, the other factors in deciding equity allocation include risk profile, time left for financial goals, financial liabilities, etc.
Action point for 2024: Determine your equity allocation based on your age and other factors, and accordingly start investing in equity mutual funds through the SIP route.
10X life insurance rule
A life insurance plan provides a financial backup to your family in case of your untimely death. Personal finance experts recommend the 10X life insurance rule, according to which your life insurance coverage should be ten times your annual income. Some experts recommend the 20X life insurance rule suggesting the cover should be 20 times annual income.
While this can be a starting point, there are better ways to determine an individual's life insurance coverage requirement. The calculation of life insurance coverage should consider your future income, financial goals, loans, family expenses, etc.
Action point for 2024: Buy a term life insurance plan if you have not bought it already. If you have a life insurance cover, evaluate whether the cover amount is adequate. If not, buy additional life insurance coverage.
The start of 2024 is an excellent time to understand the basics of personal finance rules and ratios. A proper understanding of these personal finance rules and ratios will set a strong foundation for you. A strong foundation will help you in a smooth financial planning journey.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.
