The Personal Finance Hour, Episode 26: Financial Rules of Thumb
Published on - November 2nd, 2009 (by J.D. Roth) 
On today’s episode of The Personal Finance Hour, I’ll join Jim from Bargaineering to discuss financial rules of thumb. Rules of thumb are no substitute for proper analysis, but they can be an excellent way to make general plans.
Today we’ll talk about things like:
- When should you repair an appliance and when should you buy new?
- When should you refinance your house?
- How much of your investments should be in stocks?
This show will air live at 3pm Pacific (6pm Eastern). It’s much more entertaining for everyone when you call in to participate. We’d love to hear your rules of thumb. When do you use them — and when don’t you? Call us at 1-347-327-9144 share (or join the rowdy crew in the chat room).
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I’ve been studying the rule of thumb that one’s retirement investment in bonds should equal one’s age, i.e. if you are 35 years old 35% of your retirement should be invested in bonds (this assumes that bonds are more conservative and as you age you should shift more of your retirement monies into more conservative investments).
This rule of thumb gets trotted out pretty darn often, it was noted in a recent, within the last couple of weeks, Money magazine money makeover.
This is not a rule of thumb I subscribe to but I have been studying it trying to learn where it came from and whether it is actually helpful (so far the answer is no).
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“When should you buy a new appliance and when should you buy new?”
Ummm.. that’s not giving us a lot of options
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Thanks, Matt.
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A post on Ask.metafilter.com regarding Real Estate rules of thumb:
http://ask.metafilter.com/133388/Can-we-afford-this-445000-house-How-can-you-tell
“your house should be (conservatively) no more than 3 times you annual income, or (more aggressively) no more than 4 times”
Conservative rule of thumb for front end debt-to-income (DTI) ratio -
28% of your pre-tax income = reasonable annual payment (before considering tax benefits):
“your monthly housing cost should be no more than 1/3 your monthly pay. The other rule of thumb is that your monthly payment will be $1,000 for every $100,000 borrowed on a 30-year mortgage”
“rules of thumb are not as accurate as spreadsheets”
“best rule of thumb is being able to at least survive on one income (the lesser, at that) for a couple of years”
“Seven New Rules for the First-Time Home Buyer” – http://www.nytimes.com/2009/09/12/your-money/mortgages/12money.html?_r=3&ref=your-money
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Abe,
For your housing rule of thumb, that means most people in the coastal areas are buying far more house than they can afford… surprise! The gov’t is still trying to feverishly prop prices up.
-Mike
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@Mike H (silly name) – The rule_s_ are from a post on ask.metafilter.com, not me.
Also, I don’t believe they support your conclusions that:
(1) coastal buyers are out of their price range or
(2) that the government should not be attempting to stabilize the housing market.
First, each of the rules require knowledge of the individual’s income and/or non-housing related living costs. Without that information, even in aggregate for recent home purchases, your conclusion that coastal buyers are exceeding their means seems inappropriate.
Second, your conclusion that our government should not be ‘prop’ing prices up’ is based on your first, baseless, conclusion that people are exceeding their means.
The general information available indicates that people are buying in their price range:
(1) Home prices have decreased 30-40% in California and beyond
(2) Interest rates have substantially decreased which has the effect of lowering monthly costs for those purchasing homes today
(3) Obtaining a risky loan is more challenging in the past forcing banks into a more active or restrictive gatekeeper against those seeking to buy beyond their means. Lenders experience and knowledge better equips them to fill this role, they simply failed to do so in the past without government oversight and regulation. They may do so again without more oversight and regulation because the experience of the market collapse will be forgotten in the rush to make loans which increases profits, but today that memory is fresh and provides a limiting force against risky loans.
Under those circumstances, it seems appropriate for our government to support home owners by keeping their property values from dropping below market value based on irrational fears or baseless conclusions. Most people buy very few houses and are not experts on market cycles, lack complete information (an assumption in economics which is not found in reality), and are most concerned with catastrophic loss rather than the potential to make substantial gains in value. Accordingly, if our government, which does have substantial information and expertise the average home owner/buyer/seller lacks, sees the market falling below rational pricing, their action is required and inaction would be a failure to protect our citizens.
It is certainly reasonable to debate what action is necessary, but a one sentence conclusion by a guy on the internet whose user name refers to female anatomy is probably not the ideal person to engage rationally in that discussion.
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Abe,
Are you a realtor by any chance?
Overall incomes are going down and unemployment is going up. There are many working part time or without overtime so as the economy picks up their hours will increase before more people are hired.
With lower employment and salary levels housing prices must come down to match available purchasing power.
The government is trying to prop up prices- with the $8k tax credit that now is extending to all buyers. The FHA is effectively making more sub-prime loans (in spite of their superior ‘knowledge’ of the market) with 3% down and is allowing the $8K tax credit to apply to the down payment, effectively making a zero down payment- just like the sub-prime crisis. The only difference is that the taxpayers now are the direct backstop.
You mention the government has a role to keep peoples property from dropping below market value…. what does that mean exactly? Isn’t the market the average value of a neighborhood?
And why not argue for the merits of lower housing prices? It’s much better for the buyer & consumer… lower property taxes, and greater affordability for people who actually did save up properly to make a substantial down payment or pay 100% in cash…
I can say prices are inflated on the coastal areas by looking at the ownership price to rent ratio… once this gets closer to 1 then it would be a better time to buy. If you can rent a place for $2500 per month that is selling for $2 million… that means the owners are subsidizing you as the renter, big time.
-Mike
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A realtor? Ha! Local government attorney, no connection to housing by any stretch. Not everyone who rejects a pessimistic outlook is connected to the housing market, just a different outlook.
I agree that salaries are decreasing (have been in real value for 30+ years) and that unemployment is up, however, that does not indicate a related decrease in housing values of 30-40%. That’s why I suggest that things are at least leveling off and the government should play a hand in slowing/stopping the collapse of the housing market: otherwise values are decreasing irrationally low based on speculation or fear rather than broad economic indications.
The FHA is not “allowing the $8K tax credit to apply to the down payment” unless the buyer puts on the initial 3.5%. http://bit.ly/zmiMh (FHA press release). That does not parallel the circumstances that created the current mess and FHA loans are not “sub-prime” in any sense. They are actually put through a more rigorous vetting process because the government’s involvement in – and guarantee of – the loan process requires more regulation and oversight (a good thing).
In terms of “market value” – I probably don’t have the right vocabulary to put this right, but I mean that homes would have a certain value if all sellers and buyers knew everything about their neighborhoods, market activity, housing costs, job stability, etc. In the world of economists they assume everyone has this perfect knowledge and the price of a given home reflects that self-interested rational analysis. However, we are far from the assumed rational and knowledgeable beings of economics. Instead we make mistakes, lack perfect knowledge, and are emotional. The price of a home under according to an “econ” is what I’m talking about, where the price should be if we knew most everything we could and made decisions rationally.
***When prices start to clearly deviate from that range (too high like the last 10 years, or too low as is happening now according to many), it is appropriate for our government to step in and take corrective action.***
Re: “why not argue for lower housing prices?” Well, if I was buying then I’d argue all your points, but we’re just speculating and discussing the subject on a blog. Thus, we aim for analysis rather than self-interested argument. Further, arguing for lower home prices is also against the interest of those who saved and purchased within their means but who now have lost a substantial investment and will lose more if the market continues to collapse beyond a rational level. They are also consumers who should be protected (though I cannot count that among my own self-interests … yet).
As for rent-to-price ratios, you’re right, if that was one of the rules of thumb mentioned it would have supported your analysis (though less so that 2 years ago and not for all houses or neighborhoods – in the end it comes down to the individual house when using that particular rule of thumb which I think is excellent). Also, this particular rule is more relevant for those considering investment home purchases. In some places rent is low because there are simply few renters (e.g., many housing developments).
Good discussion!
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Abe,
Thanks for responding to my points.
Thanks for the link on the FHA – interesting.
I was reading that a number of Freddie & Fannie mortgages are in default and that new loans issued by the FHA are in danger of high default rates as well… if you are interested I will dig up and post links.
Regarding lower housing prices your argument seems centered around making sure prices don’t get irrationally low. But that is a very hard metric to measure… when housing is in a bubble, people are flipping and thinking that real estate only goes up isn’t that irrational? And so now we are 30-40% below the ‘peak’, so what? Adding a homebuying credit merely distorts the market. So does deducting mortgage interest by the way.
And if someone buys the house to stay there in the very long term (10 years) why does it matter if they are losing on their investment if the propeerty value goes down? Shelter is shelter. I would argue that lower prices means lower real estate taxes which benefit everyone except the local & state governments.
Even for owners I would maintain that the price to rent ratio is a fair metric. I was living in coastal NJ from 2002 – 2006 and even though I was earning above 6 figures I would not buy a house simply because the price to rent ratio was so out of whack. That and I was single at the time so no need to buy a house. Prices kept going up surprisingly but I was happy with my 2 bedroom apt costing $1100 per month. I cculd have made money flipping but instead I saved my money and bought a condo in Asia (where I now live) in cash for $175K USD – the price to rent ratio was such that the monthly rent is $1500 so it really makes sense to buy.
I would think about coming back to the US if I can find meaningful work there and would buy a house if the price is affordable. As long as there are distortions (ultralow interest rates, homebuyer tax credits) I will patiently wait.
Look at the cash for clunkers stimulus- the dealers are the party that came out most ahead as prices were sold at sticker for people who needed to desperately buy to get the government rebate. Look for housing to do the same (benefit the realtors).
-Mike
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