12 key financial rules of thumb
One of the biggest enemies of getting your financial life together is TMI. Financial experts want to tell you way too much information about how to invest; how to deal with your debt; how much you ought to have in savings and pretty much everything else. Before ever getting to the meat of the issue, many of us find our eyes glazing over as we wonder about dinner.
The problem with tuning out the financial TMI, of course, is that knowing some of this information can make your life infinitely better. The good news is that there’s a simple cure: Financial rules of thumb. They’re the pithy sound-bites of finance — not perfect, but some of them are pretty darn good. If you know them — and when to apply a rule of thumb and when to ignore it — you can get by better than most without the need for an MBA.
For simplicity’s sake, these are broken into categories.
The 50/30/20 rule: This declares that you need to spend half of your take-home income on needs — like food; rent; utilities and insurance. Spend 30% on wants, like nice clothes , entertainment and a decent car. Spend 20% on paying down debt and saving for long-term goals, such as a house down payment, a college fund or a retirement account.
Apply: When your debt is under control and at least half of that final 20% is being saved for long-term goals.
Ignore: When the entire final 20% is being used to repay debt. In that case, seek help from a non-profit credit counselor to figure out where you’re going wrong and how you can fix it.
Emergency fund rule: You need to have 3- to 6-months of living expenses in the bank for emergencies.
Apply: If you have a pretty stable job; a family that will help you out in a pinch; two incomes; and no serious health problems.
Ignore: If you are self-employed or working in an industry that’s dicey, have health issues, and no ability to move back in with friends or family when everything goes wrong. In this case, you’d need a bigger emergency fund — a year’s worth of living expenses would be ideal.
Retirement savings rule: You need to save at least 10% of your income for retirement.
Apply: When you start saving right out of college.
Ignore: If you start saving later — like 35 or 45. In that case, you’ll need to save a larger portion of your income or live lean in your Golden Years. Check out our Smart Retirement Planning guide to figure the right savings amount.
College debt rule: Don’t borrow more than your first year’s salary. Of course, you don’t know how much you’re going to earn in your first year, so this rule is a little squishy. But, it’s wise to estimate it before you enroll. That will allow you to weed out colleges that are so expensive –and so unwilling to give you aid — that you’ll graduate buried in debt. Or majors that require advanced degrees that promise very little economic remuneration.
Ignore: If you’re going into medicine or another profession where your first year’s salary has no bearing on what you’ll ultimately earn.
College aid rule: No matter how unlikely you are to get aid, fill out the FAFSA (Free Application for Federal Student Aid). It’s the gateway to getting everything from grants and scholarships to federal student loans. And, even if you don’t need a student loan, you might want to get a small one in your final year of college to establish a credit history.
Ignore:When you or your parents are millionaires and happy to pay for everything with no help from the government or private scholarships and grants.
Student loan rule: Never default on your student debt. There are two reasons for this — it will trash your credit rating; add hundreds (maybe thousands) of dollars onto your loan obligation; and the government can haunt you (and confiscate every tax refund) for the rest of your life, or until the debt is satisfied. Besides, with the flexible payment options now available, there is absolutely no need to default on a student loan. Ever.
Apply:Always. No exceptions.
Buying a house
20% down payment rule: This rule is essentially enforced by lenders for practical reasons. Before a bank is going to put up hundreds of thousands of dollars to help you buy a home, they want to be sure that you’re putting up some of your own. Otherwise, you might be tempted to walk away if the home’s value fell or criminals moved into your neighborhood. After all, they don’t want to get stuck with your mistake. So they’ll either require a 20% down payment or charge you more — often a lot more — for your loan. Because even a small hike in the interest rate will cause you to pay thousands of dollars extra over the life of the loan, it’s smart to scrounge up the traditional 20% down payment before you buy.
Ignore: If you can get low-cost financing — maybe from a relative — for a portion of the down payment or if you have wildly wonderful cash flow that would allow you to build equity — or repay a second mortgage — quickly. (For more about buying without 20% down, see Should You Buy a House.)
One-third gross pay rule: This says that you can afford a mortgage (inclusive of property tax and insurance) that equates to about one third of your pay. So, if you earn $5,000 a month, the cost of your home mortgage, property tax and home insurance) shouldn’t amount to much more than $1,650 per month. How much home will that buy? Assuming a 4% interest rate on a 30-year fixed rate loan, and that property tax and insurance will add up to about 1.5% of your home’s value each year, you could afford a $275,000 loan. If you had 20% down, that buys you a home worth about $345,000.
Apply: When you have a fairly average income and assets.
Ignore: When you’re rich. The formulas are based on discretionary income and when you’re really well heeled, you have far more discretionary income than they’re imagining.
Rule of 72: Says that you can figure out how long it will take your money to double by dividing 72 by the investment return. Thus, if you’re earning 6% on your investments it will take 12 years for your money to double (72 divided by 6). If you’re earning 10%, your money will double in just over 7 years.
Apply: When you have a fixed amount of savings.
Ignore: When you’re adding to the account regularly because this rule will understate how much you’ll accumulate.
Five-times pay rule: There are a bunch of rules of thumb about how much life insurance you need. Unfortunately, many of them are made up by life insurance salesmen. But this is a common one and it’s based on the idea that if the primary breadwinner were to die, his or her survivors would have expenses that they’d have to cover, possibly for several years, to survive without that person’s income. Here’s the problem: There are no good rules of thumb for how much life insurance you need. Some people need a lot — 10 times income or more. Some people don’t need it at all because they either don’t have dependents or they have so much in the way of assets that their dependents will be able to handle any necessary expenses with the decedent’s estate.
Apply: If you simply can’t face thinking about what would happen to your dependents if you died. Five times earnings may not be exactly what they need, but it’s sure better than nothing.
Ignore: If you have no one who depends on you for financial support. In this case, you don’t need life insurance. Also ignore this when you have young children, a stay-at-home spouse and more debt than assets. When a lot is riding on your income, you really need to do a better estimate of how much life insurance you need. Check out our story on estimating your life insurance needs; and know that term insurance is cheap. Don’t be afraid to round up.
Subtract age from 100: Want to know how much money you should have in stocks versus bonds? The rule of thumb is to subtract your age from 100 and invest the result in stocks. In other words, at age 40, you should have 60% of your assets in stocks. When you’re 70, you should have 30% of your assets in stocks.
Apply: When you’re risk-averse and investing solely for retirement.
Ignore: When you’re investing for multiple goals, such as kids’ college bills, a house and retirement. Also modify the rule when you are solely investing for retirement but have the ability — either because you’re calm in a crisis or because you have enough savings to handle market upsets — to ride out bad markets. Then, you might use a rule like “Subtract your age from 110.” Or 120. That gives you a more stock-heavy portfolio that is likely to earn better returns over time.
4% Rule: If you want to make sure your money lasts throughout your retirement, withdraw no more than 4% of your savings in the first year. In following years, you can take that amount, plus an inflation adjustment.
Apply: If you are earning more than 4% on your investments, this is a great rule of thumb that allows you to never run out of money.
Ignore: If the market tanks in the early years of your retirement. In this case, you’ll want to adjust this rule (or seek the help of a financial advisor) to ensure that you don’t run out of money. Experts at the giant mutual fund company T. Rowe Price have found that bad markets early in retirement can cause investors to run out of cash even when they’re following the 4% rule. But even small adjustments can make a big difference. If, for example, the market tanks two years into your retirement, forego your inflation adjustments for a few years. Or, if the market drop is severe, consider cutting back more sharply on retirement withdrawals until the markets recover. The good news is that if you take this adjust-as-you-go approach, you can also spend a bit more in years when your investment returns are unusually good.