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
been using, as well as several others I found online. Thanks to those who follow me on Twitter, who also contributed
For example, “I hate rules of thumb — they are a poor substitute for proper analysis.” He’s right,
Careful analysis always yields the best results. (And there are times when you need the advice of a financial professional.)
the same, it’s often convenient to get a quick estimate of financial numbers. For those situations, it’s helpful to know
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
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,
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
of expenses. (The most common suggestions range from three to six months of expenses.) However,
a clever rule of thumb to determine how much to save during a recession: Your emergency fund should cover X months of
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.
“Don’t let raises get to your head. If you get a raise, yay! More
(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
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
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.
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
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.
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.
Long-term, the stock market averages about a 10% return. But remember: average is not normal. Also, many experts
(including Warren Buffett)
expect stock returns to be lower over the next few decades.
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.
“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%
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
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
lower today, and now it often makes sense to refinance your home when interest rates have dropped by 1% from your c
As always, use this rule of thumb as a flag to start looking, but run the numbers before you take action.
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
guidelines to use when shopping for a vehicle:
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
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),
price tag and divide by 60. Looking at a pimped-out Mini Cooper S? Double that $30,000 sticker price to get $60,000,
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),
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
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
spending, you don’t want credit cards at all!) For more information, read about how to choose a credit card.
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).
Copyright © 2002
* 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
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.
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