Financial Rules of Thumb
Helpful “Rules” to Quickly and Easily Tell How You’re Doing Financially.
Just to be clear, these are my rules of thumb. You may or may not agree with them, but I’ve found these various easy-to-remember things useful in everyday life. Also remember that these are just guidelines. If you are staring at a major life decision, don’t base your decision solely on a rule of thumb. Use it simply as a starting point, and make sure to do your research.
Now that we have that out of the way, here are some of my favorite financial rules of thumb.
Degree Investment vs Starting Salary Ratio
Think of this in terms of your total money spent on your college degree. You have to include all four years of school (for a bachelor’s degree). Compare this amount of money to your starting salary coming out of school.
For instance, if you spent $70k (4 years of school at $17500 per year) on your bachelor’s degree, and your starting salary is $70k per year, your ratio would be: 1. But imagine you spent $120k for an English degree, and your starting salary is only $40k per year. Your ratio would be 3!!
The goal of this rule of thumb is to keep your education investment to salary ratio at or below 1. And before you say this is impossible, my ratio was 0.5.
Mortgage Payment vs Income
This one is more well known. But the basic rule goes like this. Keep your total mortgage payment, including taxes and insurance, at or below 25% of your monthly take-home pay.
So for instance, if you bring home $4k per month ($48k net, around $60k gross income), buy a house where your mortgage payment is $1000 or less.
If you violate this rule of thumb, you will be in danger of becoming house poor. And just because you live in a higher cost of living area doesn’t mean you get to stretch this rule. If you can’t keep your mortgage payment to a reasonable percentage of your income, then in my opinion, you can’t afford the house.
There’s no shame in renting, and with house prices increasing in many markets around the country, you need to make sure you understand what you’re getting in to before you sign on the dotted line. Don’t sign up for a mortgage if you aren’t fully prepared for the risks and the payments.
Have Six Months Worth of Expenses in an Emergency Fund.
The six months of expenses rule comes from the average time it takes to land a new job in the event of a layoff or other job loss situation.
But this money can also come in handy in event you have other emergencies. And as anyone who has been alive for more than five minutes knows, emergencies don’t discriminate, and they can happen anytime. Better to be prepared than to have to go into debt just to survive. I recently read a terrible article touting how using credit cards instead of an emergency fund was a wise move. It seems to me, that instead of trying to be prepared, the author was simply willing to charge her future self for her poor (pun intended) present choices.
And while it may seem insurmountable to save that much if your current savings situation is meager, it’s also not impossible. You have to start somewhere. Start with a thousand, and then keep building it.
Drive Your Cars at least 10 years.
I’ve written about cars in a quite a few articles already. But the fact remains, cars are a big part of your budget. And if you can spread the purchase price out over more years, the “cost” of owning a car becomes more palatable.
For instance, if you purchase a car for $17k, and drive it for 10 years, your cost per year is: $1700. Not too bad.
You’ll always have maintenance and gas. That’s a given with either a new or used car. But if you follow this rule of thumb, you’ll end up throwing less money away on a depreciating asset.
Retirement Rules of Thumb.
Invest at least 10% of Your Income for Retirement.
This rule of thumb comes from many financial experts. And if you could save 10% for retirement, you’d be doing well. But the reality is, many Americans are not saving this much. And you really should be saving more.
The FIRE movement preaches as high of a savings rate as possible, with some consistently saving north of 50, 60, or even 70% of their income. And while I don’t think you need to save this much to retire with dignity, 10% is a little low. But, just like the emergency fund, you need to start somewhere. And if 10% is all you can do, do it.
Rule of 72.
This is a simple rule of thumb that allows you to quickly figure out how long it will take your investment to double.
It works like this: divide your rate of return into 72, the answer is how many years it takes for your money to double. For instance if you average 6%, your money will double every 12 years (72 / 6 = 12). If you start with $10k, in 12 years, you’d have $20k. And 12 years later, you would have $40k.
This rule of thumb isn’t exact. It’s more of an approximation. But it can be useful to get an idea of how your portfolio can be expected to grow over the years. YMMV (Your mileage may vary) 😉
The 4% Rule.
Perhaps no “rule” has received more visibility and “screen time” than the famed 4% rule. This rule refers to a withdraw rate during retirement that in theory will preserve your principal. In other words, if your investments are allocated appropriately, you can safely withdraw 4% of your portfolio during retirement.
This rule is based on a study completed by William Bengen in which he concluded that no time period from 1926 to 1976 would have exhausted a portfolio that withdrew 4% each year. And while things have changed since 1994 (when Bengen completed his study), the 4% rule is still a good starting point for evaluating your retirement needs.
Using this rule, you can back into your portfolio value if you know or estimate your expenses in retirement. And while that is not an easy thing to approximate, it does give you a rough idea of your needs. For instance, if you think you need $50k per year to live, then you’ll need to have $1.25 million in your portfolio to start ($50k is 4% of $1.25million).
These rules of thumb are quick back-of-the-envelope type calculations that are great starting points. They give you an idea on how you are doing, and where you may need to change things up a little bit.
They can also provide some guidance on future goals and plans. For instance the Rule of 72 and the 4% Rule are popular retirement/investing rules. But make sure you do your own research, and make sure you understand how these rules will apply to your specific situation.
I hope you’ve gained some useful tidbits here. Maybe something you didn’t know before?
Do you have any other rules of thumb that you like or use?
Let me know in the comments. Thanks for reading and sharing.