Best Financial Rules Of Thumb
Like most complicated things, it makes it easier to grasp a concept if we can shorten the explanation to just a few sentences or one rule of thumb. Nowhere is this more important and put to good use than in the financial world. Here are some of the best tried and true financial rules of thumb that I know. Like all general explanations there are always caveats and one-offs, but if you follow these rules of thumb to some extent you will go along way to keeping your financial world on solid ground and going down the right path. We’ll go over each rule of thumb, discuss what makes it work in general and list any caveats to keep in mind to make it work for you specifically.
The 50/30/20 Rule
The 50/30/20 rule is a budgeting rule of thumb that basically says your housing costs, either rent or mortgage, transportation costs like car payment, gas and utility bills, loan and credit cards payments, should not exceed 50 percent of your gross pay. The 20 stands for the 20 percent you should earmark for savings and investment, both for retirement and short and long term goals. That leaves 30 percent for entertainment, fun and general living expenses.
I’ve found this to be a great rule of thumb for young people just starting out and before your financial situation becomes too complicated. Even for older folks, if you can keep your finances within these broad categories, it should work well for you.
Keep Your Home Purchase To 2.5 – 3 Times Your Income
This home buying rule of thumb has come back in vogue now that we are post “great recession” and been through the big home foreclosure meltdown we had. Many people went in way over their heads on mortgages that they could not realistically afford. With easy credit and home values soaring in most parts of the US it made it easy to fall into the thinking that home values always went up. Then came the big crash and millions of people defaulted on their mortgages and home values tanked. This home buying rule of thumb says that when buying a home, keep the purchase price to capped at 2.5 to 3 times your household income.
Doing this should keep your mortgage payment at a level that you can afford and not have to worry about how you are going to make that payment each month. If home values go down you should be able to wait it out till they rise or be able to fix up your home to increase its value. Now this rule of thumb can have some give if you live in a part of the country that has really high home prices. But still, I wouldn’t suggest not going more than 3.5 times you household income regardless of where you live.
Save 10% For Retirement
This savings rule of thumb can vary depending on your age and how much you currently have saved for your retirement. In general it says that you should be saving at least 10 percent of your gross income for retirement and generally speaking you would do very well if you were steadily saving 10% of your pay. Now that said, here’s a few caveats. First thing, if your employer matches any of your savings, you should – regardless of age – try to save at least the amount of your employer’s match. So if your employer matches 6% of your pay try to start saving at least that much and work up form there to the max allowed.
For young people just starting out, you might not be making much, but then again you should be able to save at least your employer’s match because it will be a smaller overall amount. I would than try to add a percent or two when you get a raise and keep that up until you max out. With many years to retirement, now is the time to plant the seeds for your financial fortunes to grow.
For the over 40 crowd, you will need to do a little more calculating. You’ll need to figure out where stand now, how much you will need in retirement and how to bridge the gap if any to getting to the promise land of a happy retirement financially.
Related Post: Optimizing Your Post Retirement Drawdown Plan
Your Portfolio’s Bond Percentage Should Equal Your Age
This portfolio rule of thumb has been around a long time and I believe it is showing its age. With people living much longer now I’m not sure a 50 year man should be 50% in bonds and leaving only 50% for stocks. In this day and age of very low interest rates and again with the longevity factor I would suggest maybe updating this financial rule of thumb. I would rather go with “the amount in stocks should be 110-120 minus your age” depending on the level of risk you are comfortable in taking. That would mean a much higher allocation of stock to bond ratio then the old rule. I think this is warranted in order to make your money last longer in later years. Yes, it is more riskier but so is the risk of running out of money too.
20/4/10 Rule Of Car Buying
The 20/4/10 car buying rule of thumb states that when purchasing a vehicle you should put 20 percent down, finance for no more than 4 years if necessary and spend no more than 10 percent of take home income on overall transportation expenses. This rule is an easy one to get away from as it’s easy to fall in love with a new car no matter what the cost. We also sometimes view our automobiles as an extension of our personality and want to make a good appearance. If you fall into that trap it’s easy to overspend on your car purchase. By following this rule you can figure out upfront, what you should spend on a car purchase and therefore adjust your expectations accordingly, and hopefully stay out of debt by not trying to impress everyone with your car. On the other hand if this rule of thumb shows you can afford the car of your dreams than by all means I’d say why not.
Your Emergency Fund Should Equal 3 To 6 Months Expenses
This rule of thumb is a very important one and one that unfortunately a lot of people ignore at their own peril. This financial rule states that you should keep in savings 3 to 6 months worth of your expenses. This is designed to cover you for some of life’s down times that seem to happen when you least expect or can afford them. The car breaks down, the refrigerator dies, you have a sudden medical emergency or you lose your job. These things happen to everyone and having 3 to 6 months of a cushion can soften the blow a little. At least it could remove some of your financial worries a little.
Now the 3 to 6 months figure is a general rule and depends on your age, job outlook and responsibilities. If you’re young and able to lean on parents or don’t have a family to support you can probably get away with having just 3 months worth of expenses. If you are older, have a family to support, or have a high paying job and your expense are high I would suggest at least 6 months worth of savings for expenses and would probably look at having maybe a year’s worth set aside.
Now I wouldn’t get too cute with this money. If it is 3 months I would keep it in CDs or money market accounts. If it is more than 3 months maybe you could look at bonds but not junk bonds. You want to be sure this money is there when you need it. And you will need it at some point most likely.
Put At Least 20% Down On Your Home Purchase
The 20 percent down on a home purchase is a pretty solid financial rule of thumb. If you can put down 20% on your home you most likely are well within the 2.5-3 times your household income on overall price rule stated above, and can afford the home. Putting down 20% would also most likely keep you from paying mortgage insurance (PMI) and lower your monthly payments. It will also start you off on good footing as far as having equity in your home should you need to sell it sooner than you wanted.
Rules of thumb are meant to be general and just guidelines to help you along the path. But if you follow these aforementioned rules of thumb as close as you can depending on your situation and stage in life you should do well.
Resources For You:
- 10 Books You Should Read For Personal Finance
- The Truth About Money 4th Edition
- Time For A Financial Checkup
Share This Post