From a financial perspective, living today and planning for the future are difficult tasks. It takes work to figure out how to allocate our earnings both for our current needs and for investing in our futures, including retirement.
Luckily, we can learn a lot from all those who’ve already done it. If we follow some of the “blueprints” or financial rules of thumb they’ve left for us, we have a better chance of successfully managing our money now and planning a stable financial future.
If you’re a bit of a rebel, it might be time to set your rule-following issues aside. Many of these financial rules of thumb have helped people reach financial independence and continue to build wealth. Ditching the fear of running out of money in retirement is priceless.
But don’t blindly follow each rule either. Take time to understand each financial guideline below – and remember, they may not fit every situation. While we think you’ll agree with or see the wisdom in many of them, sometimes rules are meant to be broken.
Financial Rules of Thumb
Eight smart guidelines to help you navigate your financial life.
10 Year Rule (Vehicles)
It’s easy to fall into the trap of buying a brand new car, often spending more than we can afford. The problem is the value of a new vehicle can drop by more than 10% by the time you pull into your first gas station and 20% by the end of the first year. Some new car owners don’t consider depreciation as much as they should.
The “10 Year Rule” for car buying has its merits. To minimize depreciation and maximize your new vehicle’s value, drive any new car you purchase for at least ten years.
But many people try to get more value by purchasing cars a few years old while still planning to drive them for close to ten years (or more.) Since the value has already taken its most significant hit by then, you’ll save thousands of dollars.
With the average age of cars on the road approaching 12 years, there’s a good chance you’ll be able to drive the vehicle for 8-10 more years (depending on your circumstances.)
1st Year Salary Financial Rule (Student loans)
The “1st Year Salary” financial rule suggests that if you plan to borrow money for your college education, you shouldn’t let your loans exceed the expected salary the first year after graduation. With federal student loan repayment periods generally being ten years, this rule is easy to understand.
Based on your anticipated field of employment, you need to decide what you realistically believe your 1st-year salary is going to be. That’s the amount of school debt you should be able to pay off in 10 years, using 10% of your money each year to make payments.
Budgeting 10% of your income to pay student loans for ten years impacts what you can put toward other financial goals. Reduce the loans you take out, and you’ll have more money to save for a downpayment for a house, put into 529 plans for your kids, or invest for your future.
If you anticipate taking out student loans, make sure you use a student loan calculator to understand better how the balance, interest rate, and term of loan affects the payments you’ll have to make on the loans.
3-6 Month Emergency Fund (Saving)
If you lose your job or come down with a severe illness, how would you pay your everyday expenses without getting a paycheck?
While your loved ones might be more than willing to help, none of the options above are proactive ways to protect yourself from financial disaster.
An emergency fund is savings you set aside, so life’s unexpected events don’t have drastic consequences on your finances.
The most widely accepted financial rule of thumb for maintaining an emergency fund is saving a “3-6 Month Emergency Fund.” Simply put, you need to build up enough savings as fast as possible to cover up 3-6 months of your living expenses.
That’s usually enough time to financially recover from a job loss, injury, or another kind of tragedy without suffering irreparable financial damage.
50/30/20 Rule (Budgeting)
Many people have difficulty preparing a budget. Often, the thing that keeps them from budgeting is thinking that it’s a complicated process. That’s where the “50/30/20” budgeting rule comes in to play. Crafted by Elizabeth Warren, 50/30/20 is a fast and easy way to budget.
You would take your post-tax income and allocate it as follow: 50% to needs, 30% to wants (or non-essentials), and 20% to debt repayment, savings, and investments.
If 50% of your income goes to your needs, that will help you determine how much you can afford for housing (including utilities), transportation, food, and insurance – four of your biggest living expenses.
If you have large student loans or a lot of unsecured debt, you may have to adjust the percentages (reduce the “wants” percentage and increase the savings and debt repayments percentage) until you’ve paid off some of your debt.
20% Rule (Buying a House)
For many people, a big part of the American dream is owning a home. But deciding when you’re financially ready to make an offer can be a problem. If you’re budgeting using the 50/30/20 rule, you will already have a sense of what you can afford for a monthly housing payment.
Although it isn’t realistic for every situation, there is a financial rule of thumb for determining when you can afford to buy a home. It’s called the “20% Rule”. Saving up a 20% down payment based on the price-level of home you desire is considered ideal when purchasing a home.
If you put 20% down, you can avoid paying PMI (private mortgage insurance), and your monthly payments will be lower. You can set the money you save from no PMI into sinking funds for major house expenses so you don’t have to use credit cards or take out a home equity line of credit to pay for things you should be able to plan for.
Rule of 72 (investing)
A big part of being a successful investor involves setting goals and following a plan to meet those goals. The “Rule of 72” allows an investor to quickly estimate how long it will take to double an investment at a set annual rate of return.
While the Rule of 72 has several potential applications, it’s essentially an easy way for you to compare two or more investment options.
The calculation is simple: Take the number 72 and divide it by the anticipated annual compounded rate of return.
Example: 72/6 (a 6% annual compounded rate of return) = 12 years. If you have $1,000 to invest at 6%, you would have close to $2,000 by the end of 12 years or about $4,000 in 24 years.
You can also use the Rule of 72 to figure out the interest rate you’d need to earn to double your money in a set period. If you have $20,000 to invest and want it to double to $40,000 in ten years, you would do this calculation: 72/X = 10 years. When you solve for X, you get 7.2% interest.
25X Rule (retirement)
As you contemplate retirement, it’s useful for you to figure out your expected expenses in retirement so that you can figure out how much money you’ll need to have saved before you leave your job.
The reason you want to focus on your expected expenses in retirement is that you don’t want to plan on having to reduce your standard of living during retirement drastically.
The “25X or Multiply x 25 Rule” is an easy way to estimate how much you’ll need to have in savings to live out your retirement years.
Example: If your total annual expenses are $40,000, take that number times 25 (the number of years you should expect to live after retirement). $40,000 x 25 = $1,000,000
Knowing you need $1,000,000 to maintain your current standard of living during retirement does two things. It sets a target you can use as you make investment decisions, and it can help you decide whether or not early retirement is a possibility.
If you estimate you’ll have $1,000,000 by age 50, you can subsequently decide whether you can consider retiring at any time after age 50. If you’re concerned about retiring early and living for more than 25 years, the next rule should help.
The 25X Rule goes hand-in-hand with the 4% Rule.
4% Financial Rule of Thumb (retirement)
The “4% Rule” is also directed towards retirement decisions. While the 25X rule tells you how much you need to save for retirement, the 4% rule tells you how much of your retirement money you need to withdraw each year to maintain your standard of living.
But you do need to keep in mind that you’ll need to allow for inflation each year to prevent falling short of your annual needs.
Example: In this example, we’ll assume a 2% annual rate of inflation, and your retirement portfolio is starting the $1,000,000 used above. In the first year, you would withdraw 4% or $1,000,000 x 4% = $40,000. The next year, you’ll take the same $40,000 x 1.02% (for inflation) = $40,800. You would use this formula with inflation as a variable for each subsequent year of your retirement.
The 4% withdrawal rate is considered safe or sustainable, and it should prevent you from running out of money in retirement. This is because most of the withdrawals at this rate are interest and dividends. But the longer you predict your retirement will last, the lower the sustainable withdrawal rate you’ll need to consider using.
Rules To Improve Your Financial Health
The financial rules of thumb above are simply tools you can use to protect yourself as you navigate your financial life. As previously stated, the rules are smart guidelines for many – but they don’t make sense in every situation.
If you need further help with any of the topics listed above, consider talking with a financial professional. While following rules can make things easier, remember – this is personal finance, and everyone’s circumstances are unique.