Lately I’ve found myself using more and more financial rules of thumb. A rule of thumb is a general guideline, an easy way to approximate a value quickly. It’s not meant to be completely accurate. On a whim this weekend, I gathered together many of the general rules I’ve been using, as well as several others I found online. Thanks to those who follow me on Twitter, who also contributed suggestions.
For example, @FourPillars wrote, “I hate rules of thumb — they are a poor substitute for proper analysis.” He’s right, of course. Careful analysis always yields the best results. (And there are times when you need the advice of a financial professional.) All the same, it’s often convenient to get a quick estimate of financial numbers. For those situations, it’s helpful to know guidelines like the ones I’ve listed below.
The number one rule of saving is: Pay yourself first. Set aside your savings every month before you use the money for other things, including bills. Always pay yourself before anything else.
The standard rule of thumb is to save at least 10% of your income. I think a better goal is to aim for 20%. At MSN Money, Liz Weston writes that if you’re young, you can follow this rule of thumb: “Save 10% for basics, 15% for comfort, 20% to escape.”
Nobody agrees how much you should set aside for an emergency fund. Even the experts offer advice ranging from $1000 up to 12 months of expenses. (The most common suggestions range from three to six months of expenses.) However, via Twitter @The_Weakonomist offered a clever rule of thumb to determine how much to save during a recession: Your emergency fund should cover X months of expenses, where X is the current unemployment rate. In other words, because the U.S. unemployment is at 8.1% right now, you should aim to have enough money in the bank to cover eight months of expenses.
On Twitter, @JoyfulAbode reminds us to bank a raise: “Don’t let raises get to your head. If you get a raise, yay! More for savings! (Maybe take 20% to use in your non-savings budget.)” This is the best way to avoid lifestyle inflation.
Finally, never forget inflation. Inflation is the silent killer of wealth. The commonly-cited average U.S. inflation rate is 3% per year. But the long-term average (since 1913) is about 3.42%. As a rule of thumb, I figure that inflation runs 3.5% per year.
Because the United States had 25 years of stellar stock-market performance, many of the investing rules of thumb got thrown out the window. Now people are wishing they’d stuck to the basics. One of the most important things you can do is know your risk tolerance before you begin investing. The time to decide how much you can afford to lose in the stock market is before a crash, not after one.
For years, the asset allocation rule of thumb was to have X% of your portfolio invested in stocks, where X is equal to 100 minus your age — with the rest invested in lower-risk investments like bonds. (Thus, if you’re 30, you should have 70% invested in stocks and 30% in bonds.) Over the past ten or twenty years, “experts” began to play with that formula. Since I’ve been writing Get Rich Slowly, I’ve seen all sorts of variations on this rule, with some gurus recommending as much as 140 minus your age invested in stocks. With this guideline, I’d be 100% invested in stocks right now. This is dumb. I suspect that the current market is going to prompt a return to the traditional “100 minus your age” advice. (Another way to think of this is that the bond portion of your portfolio should equal your age, and the rest should be in stocks.)
One rule of thumb I’ve seen many places is to invest no more than 10% of your total savings in your employer’s stock. Remember that diversification is important. If your savings and your job are both with the same company, you have all of your eggs in one basket. This is risky. Famously, many Enron employees were burned when the company went under because they had been encouraged to keep their retirement savings in company stock.
Perhaps the granddaddy of all financial rules of thumb is the rule of 72. To determine how long it will take an investment to double, divide 72 by the annual return. Thus, if you’re earning a 4% return, your money will double in approximately 18 years. But if you’re getting 10%, it take just a little over seven years to double your capital.
Via Twitter, @MillionMommyND writes, “Need to cut back? Housing, cars, and taxes dominate most budgets. Make dramatic cuts to these budget busters first.” She’s right. As a rule of thumb, tackle big expenses before small expenses. If you can save 1% when shopping for your home or your car, you’ll save more than if you save 10% each month on your cable television. (Though you should still try to do that, too.) Here are some guidelines for saving on a home:
How much house can you afford? @FrugalTrader writes, “When getting a new mortgage, the balance should be less than 2x your family annual income.” So, if your family makes $120,000 per year, your mortgage should be $240,000 or less.
When lenders calculate how much house a borrower can afford, they use the debt-to-income ratio, a measure of how much of your income goes toward debt. These lending limits have crept upward with time. I’m a strong advocate of being conservative here. I believe your housing costs should be less than 28% of your gross income, and your total monthly debt payments should be less than 36%. These numbers provide ample room but prevent borrowers from being trapped by too much debt.
In the Olden Days, the standard advice was to consider refinancing your home if interest rates dropped by 2%. Closing costs are lower today, and now it often makes sense to refinance your home when interest rates have dropped by 1% from your current mortgage. As always, use this rule of thumb as a flag to start looking, but run the numbers before you take action. (Kris and I are signing on our refinance this morning! We’re dropping from 6.25% to 4.96%.)
After your home, your car is probably your biggest expense. One common rule of thumb when purchasing a car is to buy used, or to buy new and to drive it for ten years. Either one will save you big money. (Do both and you’ll save even more.) Here are a couple of guidelines to use when shopping for a vehicle:
On Twitter, @marubozo suggests the 20/4/10 rule of thumb for buying a car. You should pay at least 20% down, finance for no more that four years, and the payment should be less than 10% of your income. The first part of this rule prevents you from owing more than the car is worth, and the last two parts prevent you from buying more car than you can afford. (@ced1969 offers a different approach: “Never finance a depreciating asset, like a car. Pay cash and immediately start saving for the next one.”)
Here’s another one from Liz Weston: To approximate a new vehicle’s five-year cost of ownership (in monthly terms), double the price tag and divide by 60. Looking at a pimped-out Mini Cooper S? Double that $30,000 sticker price to get $60,000, and then divide by 60. Is it really worth $1,000 a month to get rid of your crummy Ford Focus? (Or bookmark and use the Edmunds True Cost to Own calculator.)
Finally, remember the advice of Tom and Ray, the Car Talk guys: It almost always makes more financial sense to repair your car than to buy a new one.
Save for your own retirement before saving for your children’s college education. They can get loans for school. You can’t get loans for retirement. When you’re saving, remember the following:
The standard advice is to aim to replace 80% of your pre-retirement income. I think this rule is lame because it focuses on income and not expenses. Income is irrelevant. It’s what you spend that matters. Instead, I recommend a different rule of thumb: Base your retirement needs on 100% of your pre-retirement expenses — plus 10%.
Another approach to retirement savings says that you’ll need to save about 20x your gross annual income to retire. In other words, if you earn $50,000 per year, you’ll need $1,000,000 to retire. Again, I think this is lame because it focuses on income and not expenses, and expenses are what matter. But still, this can be a handy gauge.
In his fantastic book Work Less, Live More, Bob Clyatt shares a common retirement rule of thumb. If you expect to withdraw from your portfolio for 40 years or more, you can probably safely withdraw and spend 4% of its value every year. (Clyatt notes that you can increase this amount to 4.5% with only “slightly diminished safety”.)
According to Consumer Reports, when you’re faced with the repair of an appliance (such as a television or a refrigerator), you should buy a new one if the appliance is more than 8 years old, or if the repair would cost more than half what it would take to buy a replacement.
Here are some general rules for credit cards: If you carry a balance, you want a card with a low interest rate. If you don’t carry a balance, you want a card with rewards. In either case, you want a card without an annual fee. (And if you have trouble with compulsive spending, you don’t want credit cards at all!) For more information, read about how to choose a credit card and how to get a free credit report.
Finally, if you get a windfall, use 1% to treat yourself. (Or maybe 2% tops.) Put the rest in a safe place and ignore it for six months. After you’ve had time to think about it, make your decisions. (Read more: How to manage a windfall successfully.)
Strictly speaking, rules of thumb deal with numbers. Still, there are a lot of non-numeric guidelines that I think are useful to know. Here are a few:
- Always take the employer match on the 401(k).
- Never touch your retirement savings — except for retirement.
- Never co-sign on a loan.
- Avoid paying interest on anything that loses value. (Note that under normal conditions, home values appreciate slowly, so they’re not included in this guideline.)
- Don’t mess with the IRS. When it comes to taxes, don’t try to cheat. Pay what you owe. Claim all the deductions you deserve, but don’t try to stretch things.
- In general, save an emergency fund first; pay off high-interest debt second; and begin investing (at the same time you pay down remaining debt) last.
- If you’re not willing to pay cash for it, then it doesn’t make sense to buy it on credit.
For more on this subject, check out the following articles:
- Kiplinger’s Personal Finanace: How useful are financial rules of thumb
- MSN Money: 16 favorite money rules of thumb
- Paul’s Tips: Ten good rules-of-thumb for investing
- CNN Money: A cheat sheet for millionaires to be: Financial rules of thumb
- Fairmark.com: Roth IRA rules of thumb
Now it’s your turn. What rules of thumb did I miss? Do you disagree with any of those I suggested? What financial rules of thumb do you use when managing your money?
Photo by Lucian Venutian.
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