Money Matters: Mastering Your Income and Expenses

The Basics

It is said that money makes the world go around.  People aspire for it, trade goods and services using it, make payments and receive payments. 

Income is the money received or earned for services provided. Typically, it is salary for employees working for employers, income from businesses, from passive sources and so on. Hence, income adds to the money pot.

Salary                                                  Business income                                               

Steady                                                  Cyclical, risky; steady after a while             

Recurring                                            Recurring but may be irregular                    

Known / fixed quantity                    Has ups and downs                                         

Difficult for lumpsum demands    Greater potential to earn quicker               

Dependent on employer                 Dependent on consumer                              

Fixed hours with overtime             Typically more hours / all days

Passive Income

Cyclical or steady

Recurring or irregular

May have ups & downs

Can be steady or not

Dependent on source     

Limited time; maybe stressful

Expenses are outgoing money and cover various consumption items. They include recurring ones like mortgage, rent, insurances for home, health, vehicle, food, entertainment like cable connections, phone services, utility bills, regular vehicle maintenance, transportation including fuel and so forth.  And, non-recurring ones like eating out, hospital visits, travel, repairs at home, vehicle etc.  Expenses usually vary since some recurring and most non-recurring ones are not constant amounts.  Some one-time expenses like house purchase, vehicle purchase, important functions like marriage and large medical bills are taxing for most people. The varying and lump-sum expenses are especially difficult on salaried employees.  Hence, the income should be planned to cover recurring, varying and lump-sum expenses.  If recurring expenses are covered by salary or regular business incomes, other incomes, savings should cover the rest as discussed below.

Savings are income minus expenses.  If positive, it is savings; if negative it is trouble, that is, the person or entity is in deficit or loss.  Savings are needed to cover various expected and unexpected expenses see above.  There are three pots of savings – short-term, medium term, long term, and emergency funds if money permits.  It is recommended to have a minimum 6-month living expense as short-term savings that is easily accessible in liquid form.  Medium-term savings are required usually for discretionary spendings like big vacations and unexpected events.  Long-term savings are required for items like big expenses and old-age pension. 

Medium-term savings can be partially accessible or liquid, and the other part can be locked in; typically, long-term savings are locked in for longer periods to be encashed when needed at a later date. 

Loans are taken when expenses are higher than savings. They are taken for big-ticket items like home or car purchase, large functions like marriages and for unexpected large expenses like hospital bills or death in the family.  In a philosophical world, loans should not be taken for smaller items like furniture, appliances, and other household items since we should be purchasing these only when we can afford – living within our means.  In reality, peer pressure of keeping up with the Joneses, wants more than needs, greed, bragging rights of being unique, and possessing the latest, drive many of our expenses and loans may become inevitable.  The important thing to keep in mind is the tenure of the loan, potential life changes during that tenure like addition of kids, loss of spouse’s job etc. and trying to be prepared for the worst.  Instead of being blindsided and running to last resort like parents, it may be better to plan a little ahead and instead try to help parents in their old age than take their help.

A rule of thumb is to have maximum 40% of gross income as loan payments.  If 15-30% is deducted as taxes, retirement savings and other deductions, that leaves 30-45% for living expenses and savings.  Some people calculate loans based on a single income; the other spouse’s income is 100% saved. 

There are various passive and active instruments to increase savings and add to the income.

1)  Banks, post office, pension schemes like NPS

These have a fixed rate of interest, are safe, slow, steady and have a compounded rate of growth.  For example, Rs. 1,00,000 invested at a 7.2% interest rate compounded annually gets doubled in 10 years.  Hence, the simple interest rate can be approximated at 10%. They are good instruments for long-term savings.  Some of them offer monthly disbursement of interest at a lower interest rate that may be very helpful and supplement salary income to cover recurring expenses.  Remember, many expenses are recurring, but salary incomes are finite.   If a lump-sum of Rs. 1,00,000 is available, Rs. 50,000 can be invested long-term and the other Rs. 50,000 can be in fixed deposits that pay monthly. 

2)  Finance companies, cooperative banks, investment firms and NBFCs

The above are categorized under non-banking finance companies (NBFCs) with much relaxed rules compared to regular banks. Though they entice customers typically with higher rates of interest, the smaller or zero insurance against loss of deposits, lax liquidity / reserve requirements, and less strict loan disbursements increase the risk factor.  If one wants to invest, it is at their own risk and probably best for very short terms only.  With personal experience of family members losing life savings in a failed cooperative “bank”, the author recommends against investing any hard-earned money for the sake of a few percentage points of higher interest. 

3)  Chit funds, group funds, closed groups by invite only, higher interest offering companies and other investments in say plantations, cryptocurrencies

These are to be avoided since they are un-regulated, set their own agenda, offer unrealistically high interest that is never sustainable over the longer term.  Cryptocurrency values are especially subjective since demand-supply is really fake – what tangible value do they actually have in the real world? Do not touch them with a barge pole!

4)  Mutual Funds, Bonds, Stocks and Derivatives like Options, Futures, Currencies, Commodities

Mutual funds, including index funds that track various indices are the best of both worlds – they are safer and typically yield higher than banks and post office rates.  Mutual funds are a collection of companies or sectors hence won’t fail even if individual companies fail.  If the entire sector goes through a recession, the fund will be down for extended periods.  Index funds that follow indices may be better since they have some of the lowest fees and are better diversified.  Bonds are typically lower yield but safer, stocks are riskier and some of the derivatives are extremely risky.  For a majority of people investing in mutual funds or index funds is the way to go.  The most iconic investor is the indomitable Warren Buffett – one of the greatest investors still going strong at 93 years old! Trading – day, swing , derivatives are advanced topics, some of which may give adrenaline rushes but are not worth the time and trouble. These topics are extensive and can each take up one whole session.

5)  Insurance based products 

Whole life insurance, indexed insurance and annuities provide returns on investment. Each product merits its own discussion. In brief, the funds are invested in the stock market, with the insurance companies providing a return that is say 5% less than the stock market returns.  Some offer guaranteed income with zero floor, meaning if the stock market goes negative, your rate of interest is zero and the principal is preserved.  Such instruments have a ceiling on the profit since the money managers make money when the market hits peaks.  Immediate or deferred annuities with spousal beneficiary accounts are a good hedge against the vagaries of the market.  The fees on such products are much higher than say fees on mutual funds.  Some of the good annuities are Atal Pension Yojana or LIC New Jeevan Shanti.  Something to keep in mind is that the insurance company may not be around 40 years from now when you need the disbursements and/or they may not have the solvency to cater to a large percentage of the ageing population at that time.

 6)  Real estate income

Real estate can be a source of income by directly owning and earning rents, indirectly owning through shares of real estate companies and/or investments in companies or people or group of people managing real estate and through REITs.  Direct rents can be through residential or commercial properties.  Sites or plots are another source of long-term investment. Each have their own pros and cons that are again extensive topics. 

Here we will focus a little on the most common residential rent income (more active) and site / plot (a little active but not totally passive) investments.  As an example, if an apartment is purchased for Rs. 50 lakhs and earns a rent of Rs. 20,000 per month, that translates into a simple interest of 4.8% gross or say 4.2% net.  Assuming the house value doubles in 15 years, the increase is 6.7% per annum.  The total is 10.9% per year that is barely above the bank compounded interest rate of 7.2% (simple interest 10%).  If the value does not double in 15 years, the additional hassle of dealing with tenants, loss of income from vacancy, repairs, maintenance etc. makes it less attractive than the sit-back-and-relax fixed deposits.

Sites or plots do not provide rental sources of income. Their sole value is in appreciation; if it takes more than 10 years, then it does not beat the humble deposit. Again, with hassles of illegal transactions rampant, and potential illegal occupancies, it may not be worth the hassle.

Remember, these are compared against conservative returns from safest forms of deposits.  If a portion, say 50% is in mutual funds with 8-12% compounded returns, then the average of bank FDs + mutual fund returns may be of the order of say 9% compounded that doubles your money in a little over 8 years.

7)  Venture Capital, Direct Investments in Startups

Seed or initial funding directly or indirectly through Venture Funds are another source of income.  Pay attention to the startup’s founder, their vision for growth, cash flow, competitors, reputation of VCs and their track record, exit options, and debt vs equity funding.  Often you are locked into the venture with the founders burning cash trying to grow too quickly, not having the maturity, too egoistic to adapt after the initial rush etc.  

A special mention for Systematic Approach to Investing (SIPs)

SIPs are great instruments for younger folks or to start saving in the name of kids.  They are a great drip, drip accumulation that harnesses the power of compound interest.  A meager Rs. 116 per week or Rs. 500 per month at 9% average rate, grows into an astonishing Rs. 10 lakhs or Rs. 1 million in a span of 33 years.  Somebody that starts at age 22 can be a millionaire by age 55! 

In summary, based on one’s age, the author recommends the following:

- SIP with maximum contribution from a younger age. 

- Maximize retirement contributions to the NPS.

Learn to live with a smaller net income.  Increase the savings percentage with each increase in salary or income.

- Fixed deposits in banks, post offices and other safe instruments – say 30% 

- Mutual funds and/or Index Funds – say 30-35% 

- Annuities – say 10% 

- Real estate – say 20% 

- Startups, stocks – say 5-10%

These numbers out of the total investment bucket can vary depending on age, income, risk appetite etc.  There can be divisions within each category, say for long-term FDs vs monthly paying ones, large cap vs technology vs index funds etc.  As you grow older, real estate can say go to zero, mutual funds can reduce to 20%, annuities can increase to 30% and rest in safe instruments with a small percentage in the risky ones for the “mandatory” adrenaline rush.

Happy savings!

Disclaimer:  The author is not a financial advisor nor has any finance background.