Are you one of the million people following the different financial rules of thumb? If that is your case, it is important to consider first a few things before following them.
Managing your finances can be really hard especially if you do not have enough knowledge and experience. Many people mishandled their finances causing them to be financially struggling, resulting in more problems in their life. That’s why I am advocating financial literacy because I personally experienced its importance first hand.
But fortunately, there are financial rules of thumb that were being established through time. Making our life easier by allowing us to directly base on these rules without making our own calculations. Saving time and skipped solving mathematical equations.
So, what is a rule of thumb?
What is a Rule Of Thumb
According to Merriam-Webster,
: a method of procedure based on experience and common sense
: a general principle regarded as roughly correct but not intended to be scientifically accurate
In general, a rule of thumb was formed based only on experience and not on any scientifically related experiment. It serves as a general guide only and it is not applicable all the time.
This applies also to the following different financial rules of thumb. In some instances, these rules of thumb are applicable but at some point, they are not. Especially we are talking about finances.
Let’s talk about some of the common financial rules of thumb and some of their loopholes.
Different Financial Rules Of Thumb
For Saving Money
Rule: “Pay yourself first” Income – Savings = Expenses
Everybody agrees on this. In order to be able to save, setting aside first a portion of your income is the best way and the rest spend it. But as a rule of thumb, you should save 10% of your monthly income. Personally, it is too safe to save only 10 percent of your income especially for those who are earning a decent one. It’s better to increase it to 20% or higher. You can go as far as 50% if it’s applicable to you.
Saving only 10% of your monthly income is okay for starters and those who are still young. But if you started saving money already at around 40 then it may not be applicable. You need to save as much as you can in order to prepare for your retirement.
For Building An Emergency Fund
Rule: Equivalent to 3-6 months of your monthly expenses
Financial experts have different opinions regarding how much you should have for your emergency fund. Some will go as low as 2 months equivalent of your monthly expenses and some will go as high as 12 months equivalent to your expenses. But the most common is, it ranges from 3-6 months.
But it does not consider the other possibilities – finding a job takes longer than expected. However, there is an alternative that considers the rate of unemployment and applicable during recession. Your emergency fund should be equivalent to the current employment rate times to your monthly expenses. So, if you are living in a country that has an unemployment rate of 5% then you should at least have 5 months equivalent to your expenses.
Some even prefer not to have an emergency fund at all. For them, it is not good to let a good amount of money is not fully maximized. They prefer to invest it to have a great potential of return than to set it aside earning with a little interest. Personally, I encourage everyone to have an emergency fund.
For Retirement
Rule: Save at least 10% of your monthly income
This is one of the most common rule when it comes to saving for your retirement. This may be applicable when you start saving at an early age and continue doing it. The problem with this rule it does not give you a concrete amount on how much you should have.
It does not consider also how much you already save and the time when you start saving. Saving 10 percent of your income when you are already at 40 is not ideal. And if you want to retire early, you should consider saving money as much as possible.
Rule: Equivalent to 20 times worth of Annual Income
This gives you a concrete idea of how much you should save for your retirement. But it’s based on your income and not on your expenses. Your retirement fund will depend on what lifestyle you want in the future. So if you want to be lavished, you need a large amount of money.
For Life Insurance
Rule: Coverage should equal to five times your gross salary
Whatever the value of your gross salary, just multiply it to 5 times. The result is how much your life insurance coverage should be. Nevertheless, your insurance policy should cover enough for your family if you are already married. And this will depend on many factors: number of your children, their age, debt, monthly expenses, other sources of income, and many more. To be safe, you should consider multiplying it to 8-10 times.
For Buying A Home
Rule: Cost should less than an amount equal to two and a half years of your annual income.
This is not applicable all the time since the housing prices will also depend on the location. Some housing price is cheaper compare to the other area. For instance, availing a house in a suburban is cheaper compared to the major city.
Your annual income also may be lesser compared to the other major cities. So when buying a home in an urban area and since your salary rate is based on where you are working, this rule is may not be totally fit. It is either you look for another place or you go overboard to this rule.
Rule: The 20 Percent Rule
You should pay at least 20 percent down in buying a new house. This minimizes the risk of availing a house more than you can really afford. But some people do not agree with this rule since paying down 20 percent can be overwhelming and it’s now worth it giving up your savings.
For Buying A Car
Rule: 10 Year Rule
This rule is applicable when deciding whether to buy a new car or a used one. For you to maximize its value, you either buy a used one or buy a new car and drive that car for ten years.
This rule minimizes the effect of depreciation. If you buy a used car, the depreciation will not really matter. And if you buy a new car and used it for 10 years, you were able to maximize its value. However, this rule does not put into consideration the type of car. Some cars may last for 10 years but some will not and the maintenance cost is not worth it.
Rule: 20/4/10 Rule
You should pay at least 20% down, finance it for no more than four years, and the payment should be less than 10% of your income on transportation costs.
Paying 20% down prevents you from owing more than the car is worth and the remaining prevents you from buying a car more than you can afford.
For Investment
Rule: Your age subtracted from 100 represents the percentage of stocks you should have in your portfolio.
Rule: Your age represents the percentage of bonds you should have in your portfolio.
What’s good in this rule is that it reminds you that you need to change your portfolio as you age. As you get older, you should invest to a lesser risk. This keeps you from a situation wherein you will not have enough time to cope up with your losses. But as you grow older, the growth of your portfolio will slow down.
However, as a reminder, before venturing to any investment or businesses there are ALWAYS things that you need to consider.
For Determining How Much Should Be Your Net Worth
Rule: Equal to your age times your pretax income divided by 10.
Assuming you have a Php 250,000.00 income annually and you are at 30. Your net worth should be Php 750,000.00. This is if you do not have an inheritance. However, net worth is assets minus liabilities and assets include cash, investment, and other tangible properties. So, if you want to be securely wealthy you can double this value.
Some people will find it hard to build this net worth especially those who have debt. But it doesn’t mean that they do not have a chance to become wealthy. It still depends on your strategy in life.
For Determining Maximum Debt You Can Handle
Rule: Should not exceed 36% of your monthly gross income
Your total monthly long-term payment, which includes mortgage, loan, and credit, should be less than to the 36% of your monthly gross income. But it doesn’t imply or gives you the privilege that you can take more debt as long as it does not exceed this rule. Remember, the lesser debt you have the more money you can save. You should eliminate your debt as soon as possible.
For Paying a credit card
Rule: Always pay off your highest-interest credit cards first.
Paying your credit card with the highest interest rate first is better since you can save money especially if it has the largest credit amount. That is if you have two or more credit cards that you are paying at the same time.
However, in the long run, it may affect you psychologically. It gives you the impression that it will take you “forever” in paying your debts. Since paying it takes time.
Unlike if you are paying the lowest credit amount, it gives you the motivation that you can pay all of your debt because it will take a shorter time for it to be paid.
For Determining How Long Will It Takes to Double Your Investment
Rule: Rule of 72 = 72 divided by annual return rate
Let’s assume that you are earning a 5% annual return. In 14.4 years, your investment will be doubled. Of course, there is no guarantee that this will always be the case. It can be longer or shorter than the anticipated years depending on the market movement.
For Determining How Long Will It Takes to Triple Your Investment
Rule: Rule of 115 = 115 divided by annual interest rate
This one is similar to Rule of 72, you just replaced it with 115. You can use this is if you want to have a comparison on how long will it take to triple your money instead of just doubling.
Conclusion
Being aware of the different financial rules of thumb is good. However, be reminded that these are guides only. It merely simplified things and serves as a basis only. It does not account for all the factors or circumstances.
On the other hand, these different financial rules of thumb help us in many ways. It helps us to have a starting point – basis. From making complicated decisions to a simplified one. And since these different financial rules of thumb were tested over time, we can rely on them to some point.