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The most important rule of Personal Finance

Spend less than you earn!

If you want only one personal rule that you want to follow, this is it. Spend less than you earn! It is the most important rule of personal finance.

This can be understood by a simple example. Raj and Rahul are two friends and both earn ten thousand per month. Raj spends Rs. 9000 per month and saves Rs 1000 from his salary. Rahul, on the other hand, spends Rs. 10, 500 per month, the extra Rs. 500 going on his credit card. This goes on for one year. After a year, Raj’s car meets with a small accident needing a repair job costing Rs. 4000. Rahul also needs Rs. 3000 for a medical emergency.

Now, let us analyze this situation. Who do you think can meet the emergency situation with less stress and more confidently. Yes, it is a no brainer. Raj, has a saving of Rs. 12000 over the year. Meeting a situation requiring Rs 4000 should be easy for him.

Rahul on the other hand is breaking a sweat. He has no savings and is already having a debt of Rs 6000 due to his unwise spending. He will go into more debt and the situation will worsen for him if does not start changing his spending habits and controlling his expenses..

This is a story, we all can relate to as we have been in Rahul’s as well as Raj’s position at some point in our life. However, we all want  to be in Raj’s position all the time, rather, the question here is, shouldn’t we be in Raj’s position all the time?

Thus, spend less than you earn is the first and probably the rule that you should remember, if you are willing to learn only one rule.

The important question to ask here is then, why do we frequently get into such situations? Almost everybody knows and understands that we should keep our spending under control, we still fail to follow it through? Two reasons come to mind –

  1. Emergencies
  2. Not being able to differentiate between Needs and Wants
  3. Lack of financial awareness

Lets look at both of these reasons in detail.

Emergencies:  Emergencies can strike anybody, anywhere, anytime. Your car may break down, the Air Conditioner can stop working right in the middle of June, you get the drift. Emergencies, can be of two types. Small and manageable and the big and financially crippling ones. Usually, a big heart attack can wreak one financially and as well as mentally.

So, we do know that emergencies happen. Infact, wouldn’t it be prudent to actually prepare before hand. Take a mediclaim policy for all the members in your family. Start a small emergency fund and grow that to six months of your salary. The emergencies are taken care of. More on how to build an emergency fund in the next post.

Differentiating between Needs and Wants: This is the biggest reason why many people are always short of funds, despite having a good income.This is also the reason, why some people become rich and some stay poor throughout their lives. This is what you should learn to differentiate between.

Needs are the things needed for our survival. We need food, shelter and clothing (perhaps the internet too!).

Wants are what make our lives happier and comfortable in general. We may eat at home to fulfill our need of eating, however, we may also eat a fancy restaurant. We can use the clothes we have or we can go for a the newest trend in fashion. Both fulfill our need for clothing, however, one fulfills our need and the other empties our pocket. We can buy the latest Iphone or make do with one of the Micromax phones.

Does it mean that we should live our lives like a cheapskate and always suppress our wants? Well, that would be the wise thing to do. However, here also, the first and most important rule of personal finance can help. Spend less than you earn. If your income allows you to buy an Iphone (in cash), go ahead and do so. However, buying a Micromax would still be a better financial decision! The bottomline is, once we can distinguish between needs and wants, spending less that what we earn becomes easy.

So, we know that that we have to distinguish between needs and wants. How do we do it in the real life? There are many ways to determine whether a purchase impulse is need or want. We can follow the 10 second rule, have a list while shopping, postpone a purchase. We will discuss this in another post.

For now, just think, how can you spend less than you earn and let me know in the comments!

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