Note this article is going to be read by different people, some of whom were recently hired by a Federal agency and by others who are clocking their 25th or 30th year at work. These rules of thumb, therefore, should be used with a degree of caution. Not because they are inaccurate or unhelpful but financial “rules” might not apply to everyone the same way, and you need to be cautious about how you interpret and rely on these rules to make big decisions. There are so many variations with everyone’s life that I am only parsing out the basics for now
Financial rules of thumb are handy. They are a convenient way to explain a concept that may be inherently complex and break it down to something that is simple and easy to understand and remembered. They give us a quick and uncomplicated way to make important financial decisions. They are also a good financial planning starting point. However, there are some issues with relying on a rule of thumb. It assumes that the person using it is the same as everyone else using the same rule. It paints the entire population of users of that specific rule of thumb, with the same wide brush yet we’re all different and have different circumstances. Changes do occur to underlying assumptions of a rule of thumb yet most people do not recalibrate their thinking.
1. Budgeting: The 50/30/20 Rule
This is a popular rule for breaking down your budget. It has been used for many years and more recently, Senator Elizabeth Warren helped refine it for her own family helping this rule of thumb gain popularity Step one is to calculate your net after-tax income. From there, the rule says to allocate fifty percent of your income toward necessities, like housing and bills. Thirty percent should then be used for your personal wants, such as travel, entertainment and restaurants. Finally, twenty percent goes to savings, funding additional retirement accounts and adding to your emergency fund.
If you have credit card bills, those are categorized as needs and are a part of the 50 percent. This rule of thumb can be very helpful if you’re not sure where to start, or are looking to inject some financial discipline into your life (always a good thing). It also puts into stark terms how you should be allocating your take home income. Finally, it can offer strong guidance for those that are given to impulse buying.
It might not be helpful if you have difficulty separating your wants and needs and often rationalize your spending. Further, if your home is paid off, or your housing costs are fairly low, apportioning 50 percent toward housing and bills might be excessive. (Hint, put the extra money into the 20 percent bucket). In retirement, it’s also hard to predict what all your expenses might be. See my last article to request a simple, one page financial worksheet.
2. Rule of 72 and 115: Doubling your money
The rule of 72 is a simple but useful way to approximate the time it will take to double your money or the rate of return you need to earn, to double your money. For example, if you start with $ 10,000 and know you can earn 6%, you would divide 72 by 6 and come up with 12. Therefore, it would take approximately 12 years earning 6% each year to double your initial $ 10,000 into $ 20,000. If you reverse the number input, and know the number of years you want to double your money, we would use that number and divide through. For example, say you have your $ 10,000 and want to double it in 8 years. Divide 72 by 8 and you discover it would take approximately 9 percent each year for all 8 years, to double your money. Rule 115 is the same as above, but applies to tripling your money, ambitious for anyone, but potentially achievable over time.
3. Buying a car: The 20/4/10 rule
This rule of thumb suggests that when buying a car, you should put down at least 20 percent. You should finance the car for no more than four years and spend no more than ten percent of your gross income on transportation costs.
This rule works because it can help prevent you from buying more car than you can afford and still have money left over for funding your savings and retirement. Remember to factor in auto insurance, gas and any maintenance not covered by a warranty. Note it may not apply if you own a gas guzzler and have a long commute–you’ll blow by that 10 percent figure in short order.
For example: Assume you earn $ 65,000 per year and are able to put down $ 4500 as a deposit. Also assume auto insurance at $ 100 per month or $ 1200 each year. Let’s allow for $ 500 for gas each year. Using 4% financing and 4 years for an auto loan, you could theoretically afford to borrow $ 18,000 which would cost you approximately $ 400/month, after insurance and gas. Remember, we put $ 4500 down, so you could now shop for a car costing $ 22,500 or less.
4. The 80% rule: Retirement Income
This age-old rule of thumb says that your retirement income, from all sources, should equal 80 percent of your working income. This rule has been subject to considerable debate from those who say they will only require fifty or sixty percent since they are frugal and plan to spend their retirement in front of the TV, to those who say they will need one hundred of their pre-retirement income during retirement because they have a variety of hobbies, love to travel, and are still supporting their grown children or other family members. Your best bet is to determine what your inflow and outflow might look like and balance it with how you will likely spend your time and what that will cost. Don’t forget to include possible medical expenses. As noted at the bottom of rule one, my simple one page worksheet can help solve these issues.
These are four simple and common rules of thumb that a friend or family member may have shared with you or perhaps you read it in a newspaper or online. Regardless, use these rules as they are intended: As an initial gauge to help you calibrate whether your specific finances are within the range, or not.