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  • Writer's pictureAkshay Nayak

Focusing On The Overlooked

We all have our own ways of making decisions with regard to personal finance. The methods that we employ are most commonly born out of our perceptions and the experiences we gain over time as we manage our money. Because our money management methods are derived primarily through perception and experience, they are almost always likely not to be well rounded and holistic in nature. In other words, most of our money management decisions are likely to be made with too much focus being given to some aspects of each decision, while being completely ignorant of others.

Naturally, most of our financial decisions would almost always lack complete effectiveness. So today I am going to talk about the process we usually follow when making decisions regarding certain key areas of our personal finances and money management. I will talk about the aspects that we usually focus on with regard to decision making in these areas. I will then talk about aspects that we overlook and how we can approach them so as to make our decision making process more effective.

Buying a new home is a momentous occasion and a significant financial decision for most of us. Our desire and decision to buy a new home is usually driven by emotions. Hence, we tend to overlook all other aspects surrounding the decision. We usually go through with the purchase as soon as we have enough money to buy the home of our choice outright, or at least enough to make a significant downpayment. The rest would obviously be financed by means of a home loan. But given the realities of the times we live in, we would also have to consider a number of other aspects when purchasing a new home.

Firstly, the demands that most careers place on us today have completely changed. Today almost any career, especially in it's higher ranks is likely to involve significant amounts of travelling and relocating. Those of us who are into such careers may not spend much time at home. We may also find ourselves having to live in a number of different cities over the course of our careers. And given the significant costs involved with home ownership, buying a house in one area early on in our careers would make little sense if we don't use it for long enough.

Moreover, EMIs today have quite honestly become not just expensive but exorbitant. The kind of stress that EMIs can place on our finances, especially in our early years is something that we rarely factor into our calculations. For example, paying an EMI of Rs 40,000 per month with a monthly income of Rs 60,000 would leave only Rs 20,000 available for other expenses and savings. And any stress on our income may throw our ability to service our debts into doubt. Therefore, renting a house would be a much better option for the majority of our careers.

Rental payments are highly likely to be significantly lower compared to EMIs. Renting would also give us greater flexibility to switch between houses and geographical areas should we need to relocate. Once we are at the fag end of our careers (say at age 55 or so) we would be in a much better place physically and financially to be able to make a decision to buy a house. Therefore this is a decision that is best put off until then. A few more pointers on the ideal time to make the shift from renting to actually buying a house are given in the graphic that follows.

Those of us who still wish to fund the purchase of a home through EMIs must ensure that our EMI payments do not exceed 25% of our net monthly household income.

Purchasing a car is another decision that is made with our emotions being the driving force. When purchasing a car, most of us tend to only look at the purchase cost of the car. But there are a number of other cost elements that we tend to ignore when computing the costs associated with a car. These mainly include fuel costs, servicing and maintenance charges, depreciation, driver's salary (if any) and so on. Consider the estimated costs for an individual who purchases a car for Rs 10 lakh and intends to use it for 5 years as shown in the graphic that follows.

Clearly, the effective cost of the car is a more than 50% higher as compared to its basic purchase cost (without adjusting for inflation). We must therefore give proper thought as to whether or not we are willing to spend such amounts, especially on a depreciating asset. It would also help if we were to stick to strict ceiling limits for each item of the running cost of the car. The running cost of a car includes all expenses attributable to the car apart from depreciation.

Some of us who are juggling multiple debts of significant amounts and high interest rates may choose to prioritise our debt payments from largest to smallest. And we do so based on the absolute amount of each debt. Therefore, we may end up focusing on our home loans first before moving on to other debts such as personal loans and credit card debt. But the problem with this approach is that it tends to ignore the real difference maker in our battle against debt. The interest cost associated with each of debts is actually responsible for our debts spiralling out of our control.

Therefore our approach to paying off our debts must focus on managing both the absolute amount of our debts as well as the associated interest costs. The Debt Snowball and Debt Avalanche methods are the best way to do this. The Snowball method focuses on the absolute amount of our debts. The way it works is laid out in the graphic that follows.

The Avalanche method on the other hand focuses on the interest costs associated with each of our debts. The way in which it works can be understood with the graphic that follows.

Working with a professional financial advisor would help us understand whether we would derive the greatest benefit from adopting one particular method or a combination of the two.

It is widely propagated that we must look to save at least 20% of our monthly income on a consistent basis. While this is perfectly rational, it may not always be reasonable. For example, someone living with their parents with their expenses being paid for can easily save upwards of 50% of their income. On the other hand, someone who is financially providing for themselves and their families may find it hard to even save 10% of their income. Blind adherence to such thumb rules is therefore of very little practical use.

A better way to approach the exercise of saving would be to objectively assess our circumstances and come up with a savings percentage that is reasonable in light of those circumstances. This number can later be revised upwards over time as our circumstances improve and our income grows. Clearly, almost every major financial decision that we make has aspects that are less apparent than others. But it is these very aspects that ultimately decide the effectiveness of our financial decisions. Therefore, these aspects which are usually overlooked deserve greater focus from us so as to ensure financial stability and peace at all times.

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