Sunday , 5 April 2020
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Four personal finance lessons from two women


This week’s story is about the four building blocks of personal finance and two women. One is an elderly aunt, widowed and alone. The other is a divorced niece, with a young child to take care of.

The aunt lives in a flat her husband left her, and is fighting off the daughter-in-law who wants it badly. The widow’s pension she gets is enough for her to get by. The niece got nothing from her bitter divorce and had to start over. The personal finance lessons from their experiences are noteworthy.

First, secure your source of income. No one, not even your near and dear ones, will be ready to spend on your needs unquestioningly. The aunt depends on her son for large ticket expenses that her pension can’t cover. She dreads the daughter-in-law’s questions during such times. The niece has learned in a few short years that every household has its priorities, and that even the loving siblings will not support someone they see as dependant. She found herself a job. Secure a source of income, from your job or profession or from your assets and investments.

Second, manage expenses sensibly. The niece decided to live and work in a smaller town, primarily to manage expenses better. She paid lower rents, managed her commute easily, and paid lower fees for the daughter’s education. She left behind precious friends and relatives in her earlier city. She thought she needed their support. Then she realised she was on her own. She decided to move where she can save money and time.

Third, assets matter immensely. The aunt is able to live comfortably on her meagre pension because she owns the flat she lives in. She is considering letting out the spare bedroom to a working woman to earn rent. Assets are useful for their value and the income they can generate. The niece worked with her back to the wall, with no assets to fall back on.

Fourth, keep loans in control. The niece went through a traumatic time rebuilding her life from scratch and thought owning a house was priority. The home loan EMI kept her chained to the city she disliked. When she decided to move, she sold the property and was relieved from the burden of debt.

These four points seem simple and obvious. But virtually all of personal finance’s precious lessons are encompassed in these four blocks: income, expenses, assets and liabilities. Just like the finances of a business. The business has its products and profits, the household only has its human assets.

Without an income, there is no way to meet expenses. How much income is adequate for a household is defined by its expenses. A household cannot choose to be extravagant or thrifty, but has to merely work within the defined contours of its income.

It is only when income exceeds expenses on a consistent and significant basis, that a household can build assets. Assets are cushions for future income. They buffer any loss of income; supplement surpluses; and generate enough income to replace the human asset in retirement.

When a household borrows, it draws on the future income. It spends tomorrow’s income today. The repayment of loan hits all three blocks we just discussed: reduces income, increases expenses and impairs the ability to build assets. The loan has to build an asset that will nullify all three effects to be worthwhile (ask if your home loan will meet these criteria).

All personal finance decisions are about managing these four blocks so that assets are built with surpluses. The SIP is more important than the EMI only for this reason. It builds assets, and enables those assets to grow in value over time.

The aunt and the niece examples show where these blocks are under strain. The niece needed a job as she did not have assets that generated income. For someone to support her financially, that household would have had to sacrifice its own asset building capabilities. That would have been too much of an ask.

The daughter-in-law’s disdain for expenses and greed about the house also emanate from the need for assets her household can call its own. She tries to draw upon entitlement to access the asset, but the math is the same.

When we view our household finances just as we would view a balance sheet of a business, we will focus on net worth. Or the value of assets we own over the loans we may still have to pay. We would like the maximisation of this number as the primary financial goal.

If all we have is the human asset, we would like it to earn an income that covers expenses and leaves a surplus to build financial assets. The balance sheet becomes stronger when financial assets grow. But the primary purpose of any asset is to generate income the household needs. It cannot just sit there and be useless.

Now consider your financial decisions with these building blocks in mind: Is that second house your bought with a huge EMI really useful? Don’t you need insurance so that the risk to human asset is well managed? Isn’t it important to have a surplus in the bank after meeting all expenses? Shouldn’t idle money be invested to grow in value? Isn’t the emergency fund just the buffer you need when income is under risk?

Personal finance is actually quite simple. We tend to complicate it because we like to justify our money decisions, post facto, mostly. We build assets that don’t work for us; we accept incomes that are inadequate; we fail to control expenses being overconfident about the future; and we do not know our net worth for the most part, forget managing it actively.

The aunt has leveraged the house to generate much-needed income; the niece has leveraged location to reduce expense and begin to save. Both have taken charge of their finances, so they can manage their income and expense; both have decided to protect and use the assets they own. The levers are all in our hands, always.