8 Important Financial Rules of Thumb
We make financial decisions everyday. You decide whether you want to spend $5 for a cup of coffee (don’t, seriously) or put the money towards savings. You decide whether you want to buy your dream home or wait until you have enough savings for down payment.
Personal finance means the choice is absolutely up to you and the decisions you make compound to what becomes your financial path.
Managing Your Finances
In personal finance, everything is personal. There are no hard and fast rules that apply to everyone. You can’t spend x dollars on a house if you don’t have x dollars to spend. You make decisions based on your personal financial circumstances, needs, and goals. You can’t copy someone else’s savings or investment strategy because your situation is uniquely yours.
But what remains true for all of us, despite all these differences, is we need to manage our money properly.
Importance of Money Management
Money is an unavoidable part of life. We earn it at our jobs and then we spend it on life’s necessities and luxuries. We live inside of that cycle. However, it is important that we take control of said cycle so we can use money as instrument for financial success.
And financial success begins with good money management.
You’ve probably heard the phrase “money down the drain” and that’s definitely what it feels like if we can’t manage money properly. We lose money to meaningless things unless we save, spend, and invest it properly.
We want to be in control of our money and not the other way around. Additionally, proper money management allows us to:
- Control, minimize and eliminate debts – Proper financial management lets you to tackle your debts in order of importance. Having fewer debts allows you focus on more important things like building your savings.
- Prepare for the unexpected – Surprise expenses invariably creep up, but properly managing your finances lets you keep your finances in order despite the crisis.
- Have peace of mind and security – Proper financial management also lets you to save and invest wisely so you don’t have to panic over the unexpected things that life throws at you.
- Achieve our financial goals – You’ll never hit your financial goals if you can’t manage your money properly.
Financial Management Tips
So how exactly do we manage money when there are no standard rules? This is where financial rules of thumb come in. The phrase “rule of thumb” refers to a rough estimation or practical rule and is not backed by a specific measurement or science, but makes sense logically. The financial rules of thumb are concepts and numbers that help you achieve the best financial decisions based on what’s logical and sensible, so that a difficult financial decision comes off as easy.
The rules of thumb do not apply to every situation or individual, but they’re certainly great rules to live by to get started with properly managing your finances. According to Michael Finke, a personal financial planning associate at Tech University in Texas, “rules of thumb are generally useful for most households, because we found through our research that simplicity is good, (and) that complexity is really the enemy of good household financial decision-making.”
In other words, financial rules of thumb aim to simplify the overly complex and mathematical ideas so that we can comprehend our finances more easily. It is also with much hope that these rules will guide us to making the best and wisest financial decisions. The financial rules of thumb cover all aspects of financial management, from saving, retirement, home and car acquisition to investing.
Rules of Thumb to Follow for Proper Money Management
So what are the rules? Regardless of where you are in life right now, you’ll find yourself making a huge financial decision at various points. If you’re unsure about the precise track to take, you can refer to these financial rules of thumb as your starting point.
General Budgeting: The 50/30/20 Rule
The first and most basic step in managing your finances is through a budget. It allows you to set aside money for a certain purpose. But the thought of budgeting can be very daunting for some people.
If you’ve never budgeted before, you need to follow a certain methodology. You want to use your money to cover all your expenses and still have some savings left. While there are various budgeting methods out there, this one is probably one of the most popular.
The 50/30/20 budget breaks down your budget into three simple categories.
- 50% – for basic necessities
- 20% – for financial goals
- 30% – for flexible spending
In this budgeting method, you put half of your salary towards the necessities. These expenses are non-negotiable and essential for day to day survival, which include food, grocery, housing, utility bills, transportation, and health care.
Next, you need to nail down your financial goals and spend 20% of your income on them. This is where you get funds for paying debt, retirement, investments, savings, and other goals.
The last 30% of your income is put towards any expense that is not a basic necessity or categorized as a goal. For instance, if you want to put the money towards shopping or a vacation, then the money comes from this portion.
Advantages of the 50/30/20
The best advantage about this financial rule of thumb is it covers all the angles. There are other variations of this budgeting method (such as the 80-20 budgeting method), but the main purpose is that you have a purpose for every dollar you earn.
Perhaps the most important aspect in following a budget like this, or for basically any budgeting method is to carefully discern your needs and wants. You have to draw a clear line between the two so you can effectively cut back on certain expenses when you need to tighten the budget.
You can modify the percentages based on your financial realities. If your housing costs don’t add up to 50% of your income, you can put that money elsewhere. If your only forms of entertainment are books and movies, then 30% might be too much. The thing is, you can adjust the budget so it works perfectly for your own personal financial circumstances.
Buying A Car: The 20/4/10 Rule
For many of us, having a car is more of a necessity than a luxury. We need to get from A to B whether it’s just for errands or to and from your workplace.
However, cars lose their value the moment you buy and drive it off the lot. It’s important to remember that you need to acquire assets that increase in value over time in order to become financially stable, but sadly, a car does not fall into this category. Even if you negotiate well and get a good price, you’re just minimizing the depreciation of its value. This makes it trickier to buy a new car which is why the 20/4/10 rule is great for buying a car.
What this rule of thumb tells us is you should drive the car for at least 10 years, give at least 20% in down payment, and finance it for no more than four years.
The math behind this rule is super important. First, you need to put down at least 20% down on the total sticker price. Dealerships may let you to put less than this amount down, but 20% is a great figure because it immediately gives you some equity and prevents you from getting upside down on the loan. This will also give you some leverage during the negotiation to get a better interest rate.
Variants on the 20/4/10 Rule
You also want to make sure that you finance your car loan for no more than 4 years. This builds equity on the car faster and helps you get a better interest rate rather than a longer loan. There’s also the possibility of getting “car fatigue” where you get tired of the car and want to trade it in or get a new one. Regardless, having a 4 year note helps you own the car faster so if you do get tired of it, you won’t have to worry about paying off your car.
Lastly, you should also keep the transportation costs under 10% of your income. That means your monthly car payments, gas, insurance, and maintenance. Another version is this is that you should drive the car for ten years, whether it’s brand new or used. This way you don’t have to suffer from as much depreciation if you decide to sell the car in the next two years or so.
Remember, cars lose value quickly, so it’s often better to drive it for as long as possible. Some people even choose to drive their cars to the ground to not suffer from a significant hit of depreciation.
Buying a Home: 20% Down Payment
In their book The Millionaire Next Door authors, William Danko and Thomas Stanley describe the home as this type of investment: “If you’re not wealthy, but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realized income.”
A home is the single most expensive item you’ll ever purchase in your adult life, and the longest-lasting. But unlike vehicles that depreciate in value over time, homes generally appreciate in value over time. Simply put, homes create wealth since they become part of your assets. However, a home can only be considered an asset if it doesn’t make you house poor. Otherwise, you would be spending too much on your mortgage that you can even barely give the home its proper upkeep.
Saving for Your Down Payment
When buying a home, it is important calculate your down payment since both the financial rule of thumb and finance experts agree that 20% is the sweet spot, if not the gold standard, for various reasons.
First, having this amount ready instantly builds your equity over the home since you basically own 20% of the house already. It also protects you from market fluctuations because you already have this equity in place.
Second, the 20% down payment gives you great negotiating leverage. Most lenders will look at this amount very favorably, which will make you more likely to qualify for the loan.
Additionally, the Consumer Financial Protection Bureau now requires that potential homeowners have a 43% debt to income ratio. Since having a 20% down payment will help reduce the amount of your monthly mortgage, it also helps bring down your total monthly debt.
And don’t forget interest rate! With at least 20% down, lenders will be much more inclined to give you a better interest rate which can save you tens of thousands of dollars over the life of the loan.
Plus, you wouldn’t have to pay PMI or private mortgage insurance, which is just another expense for home purchases with less than 20% down payment.
Buying a Home: 2.5 Years Income For Worth of a House
Back when homes were more affordable and the lending market was more lenient, people were able to purchase homes without worrying about their income. But over the years, a new rule of thumb came to life with income as the main consideration. This rule tells us that the worth of your home should not exceed 2.5 years of your household’s combined income.
So if you earn $100,000 a year, you should not buy a home that exceeds $250,000 in price. However, if you have other ongoing financial obligations like child support, student loans, or an expensive vehicle loan, you need to bring the amount down further so you don’t wreck your finances.
Apart from that, you also have to consider several important factors like having an emergency fund, job stability, reducing or eliminating your debts, investing in your retirement, and having insurance. With all of these in place, you’ll be in better standing to legitimately afford your home and not end up being house poor.
Retirement: 10% of Income
You’ve also probably been told that you need to start saving for retirement as early as possible, but how much do you really need to save for a comfortable retirement?
The golden rule has always been to put away 10% of your income (however much that is) towards retirement. This rule is further magnified by the words of Warren Buffet “Do not save what is left after spending, spend what is left after saving.” This is an old and classic rule and one that’s also proven to work.
Why just 10%?
The magic in 10% is that it’s a simple and memorable figure to remember. Regardless of how much you earn, setting aside 10% of your income for retirement as early as possible will give you the best advantage — the power of compounding.
However, some experts say that 10% is a great guideline for people in their 20’s or who have just started their careers. As you get into your 30s and 40s, try to put away at least 15% to build a more stable nest egg.
But what about those who started saving for retirement later in life?
When should you start saving?
Well, we’re never too old to save, but if you want to play catch-up for all those missed years, you need to be more aggressive. You won’t have $800,000 in retirement savings at 65 if you started saving at 35. You’d need to have had started at least a decade earlier in order to reach this amount.
And what if you want to retire earlier than everyone else? Naturally, you need to save more than 10% of your income. If you plan to retire in your 40s to 50s, you have to be very aggressive, much more if you intend to live a lavish lifestyle.
If you’re looking to get started with retirement funding, you don’t have to look very far. Most employers have 401K plans that you can match. This is an easy way to start investing “free money” that you can use when you retire.
Tips on Saving for Retirement
But the 10% savings rate is not perfect at all angles. The catch is this generic rate does not take into account the type of life that you’d be living when you reach retirement age. Are you planning on traveling to every country a couple of times a year or would you like a simple life in your old family home and spend your time gardening?
Also consider the inflation rate a couple of years from now. Goods and services may become pricier than they are today. You need to plan for the kind of lifestyle you intend to live.
Now, considering that you’ve already saved up for retirement after all those years you’ve toiled at the workforce. How much can you withdraw from the fund to keep things not just afloat, but also stable? There’s another rule of thumb for that – the 4% withdrawal rate.
According to the book “The Bogleheads Guide to Investing” this rule says “if you want to make inflation-adjusted withdrawals, increasing the amount withdrawn each year in accordance with increases in cost of living, begin by withdrawing no more than 4 percent of the portfolio’s beginning value.”
The idea of the 4% withdrawal rate is based simulated market conditions. It is a conservative and safe percentage that gives your investment portfolio better chances of surviving even for the next 30 years. With this withdrawal rate, your portfolio still enjoys a stable growth and security. Some experts assert that withdrawing more than this rate runs the risk of running out of money in the following years.
Retirement: 20x Worth of Annual Income
Another popular rule for retirement is to save 20 times of your annual gross income. For instance, if you earn $50,000 a year, you need to have saved $1,000,000 by the time you retire. This gives you a solid ballpark figure to aim for and is often easier to calculate and remember.
While this rule works, it’s also a quite risky. It only focuses on what you can save now, but did not take into account the rate of inflation. You’ll probably need more when you retire because goods and commodities are expected to cost more in the future.
Emergency Fund: 6 Months of Expenses
The emergency fund is a fundamental concept in personal finance that’s preached by financial gurus.
What exactly is the emergency fund? Like the name implies, this is the fund that you use in times of need. When you plan a budget, you typically allocate your income to all known expenses – rent or mortgage, utilities, food, transportation, grocery, health care and so on. You also include savings as expenses, like student loans, retirement, vacation, and even investments. But what’s often left behind are those you don’t always see.
The emergency fund is a safety net for any urgent expense that’s not accounted for in your budget. It’s the fund you tap when your roof leaks, your car breaks down, or out of pocket medical expenses. Instead of using money already set aside for food or entertainment, you pull from the emergency fund and keep the rest of your finances intact.
Why 6 months?
Now the question is: how much should you keep in emergency fund? Experts say that you need to keep 6 months worth of expenses in your emergency fund. So if you earn $3,000 a month, you need to have $18,000 ready to go. This will cover nearly any unexpected expense as well as be a solid cushion in case you lose your job.
This will give you some peace of mind and security, but it’s not just the same for everyone. Many people struggle to scrap together $1,000, so it will even be more difficult to save up to 6 months in emergency fund. Some people are comfortable knowing that they can always take cash advances from their credit card when necessary while others are happy to have $500 stashed somewhere.
Match it to your comfort level
To begin determining your magical number, you first need to qualify what’s an emergency for you. Perhaps there’s an illness that can’t be covered by your health insurance. An accident could leave you disabled and unable to work for months. If you have a lot of recurring monthly expenses, you need to save more. You might only need 3 months worth of emergency fund.
Your emergency fund heavily depends on your comfort level, income stability, and financial needs. It’s important to remember that you need to change your budget when an emergency hits to at least minimize the effect. Don’t forget to replenish the emergency fund as soon as you can.
Life Insurance: 5x Gross Salary
The thing about insurance is you need to get it even when you don’t need it because when you need it, you might not be able to get it. You need to prepare for the worst.
While we never want to need life insurance, it helps protect your family in case of an unexpected death. This becomes even more important if you’re the main breadwinner or if your spouse makes significantly less than you. You don’t want to leave your family in financial distress.
However, there are people who don’t need a full-fledged life insurance. People who are single with no dependents can have a small policy to cover funeral expenses, but the same is not true for people who who have families that rely on their income to survive. If you’re the one bringing in the income into the family then you need ample life insurance.
That being said, it’s important to nail down the right amount of life insurance policy. According to rule of thumb, you need a policy that covers five times your gross salary. This will cover expenses and bills so your family can come to terms with this new reality without you in it.
Rules Of Thumb Aren’t Set in Stone
Did you get a home with 25% down payment or saved 15% of your income towards retirement? Did you only save only three months worth of expenses in your emergency fund or purchased a whole life insurance instead of the more popular term life insurance?
Don’t worry if your finances are different from what’s outlined here. These are, after all, only rules of thumb and not laws. They’re tried and true guidelines for the most important financial decisions and are helpful if you’re looking for simple financial advice.
Always remember that you have a ton of freedom when it comes to your finances. It’s your money so you call the shots. These rules are there to simplify the sometimes overly complicated mathematics of finance.
Sometimes you need to experiment with one method to another in order to nail the best one financial circumstances. If those don’t conform with the financial rules of thumb, but work for you, then there’s no reason to force them.
Finances can be overwhelming and complicated. There are many decisions that you need to make on a daily basis, but if you’re gunning for the best possible choices, you need to have some advice about what works and what don’t.
These financial rules of thumb don’t apply everyone. You need to consider individual differences in terms of financial circumstances and goals. The good thing is, you can make financial plans loosely based on these rules to give your finances some semblance of direction. And if some of these rules don’t apply to you, you can simply bend and modify to get the most advantage.