6 Financial Rules of Thumb

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6 Financial Rules of Thumb

I wonder how many of you are big readers. You know the kind, the ones who can read a book for a week or sift through endless reams of data and advice to help them develop a financial plan that will lead them down the path to prosperity.

​​​​​​​However, if you are like most people and do not have the time to read through a mountain of books, magazines and websites (or have the inclination to do so), then this article is for you. It will list the most important “rules of thumb” for financial planning.

1. The savings/investment rule:

Pay yourself first: Aim to put at least 10% of your take-home pay

I’m sure you’ve seen this rule of thumb before. I first read it in The Richest Man in Babylon. As you will learn, paying yourself first is the most important bill you will pay each month.

The best way to implement this rule is to make it automatic. Have 10% of your take home pay taken out of your paycheck and deposited into a separate bank account. If your​​​​​​ employer does not allow you to do this, simply set up a transfer between your main account and your “ten percent” account equal to ten percent of your salary.

If you already have a well-funded emergency fund and your short-term goals are funded, you can put all ten percent into a retirement plan. Of course, if you put 10% aside in your retirement plan, you will contribute pre-tax, which is more than 10% after tax.

2. The short-term rule of thumb:

So-called “Bad” debt should not equal more than 20% of your income

Short-term debt includes your car and student loans, as well as your credit cards and other forms of debt. Essentially everything except your mortgage. You must list all your outstanding liabilities and their respective minimum/monthly payments. Now add up the minimum/monthly payment amounts and you will come up with a figure.

Take this number and divide it into your monthly take-home payment.

If the result is more than 20%, you carry too much revolving debt. New entrants to the workforce or recent graduates often have a higher debt-to-income ratio because of their student loans and entry-level jobs that pay low salaries.

Compulsive spenders also have a problem because they spend every dollar they make.

You should aim to put at least 20% of your net pay towards paying off your outstanding debts. If you stop adding to your short-term debt today, you will find that you can pay off most of your short-term debt anywhere from 3-7 years.

3. The rule of thumb for housing:

You must spend less than 36% of your monthly salary on housing

This rule of thumb is mainly for homeowners, but if you rent and spend more than 36% of your monthly paycheck on rent, you live in NYC or San Francisco and it’s time to find a new place. Either that or find another roommate.

Why 36%?

Well, banks like to see that the cost of your monthly mortgage payment, taxes, insurance and utilities won’t place an undue burden on your finances.

In short, they calculate the cost of living in your home and know that if you have 36% of your housing costs, you have probably bitten off more than you can chew.

Regardless of what your current percentages are, aim to reduce these percentages over time. Just because a bank is willing to lend you up to 28 percent of your gross monthly income, it doesn’t mean you have to borrow that much money to buy a house.

The less money you borrow, the faster you can pay it back and the higher your monthly cash flow will be (because you spend less on your mortgage). The less you spend monthly, the more you have to invest for your future.

4. The pension rule:

You should save about 20 Times your annual gross income before retirement

There are a whole bunch of calculators and spreadsheets on the internet (I have one too) that you can use to figure out how much you need to retire. I have never met anyone who has the patience to fill out one of these and they only take two minutes to complete! The solution is what author Robert Sheard calls the Twenty Factor Model.

Essentially the formula is:

Financial independence = annual income requirement X 20

The formula is based on two centuries worth of returns on the stock market and the real return (5% annually) you can expect to earn after taxes, expenses and inflation.

If you have 20 times your annual income requirement, it means that with the prescribed withdrawal rate of 5% annually from your nest egg and the annual expected net return on your investments of 5%, you will never run out of money.

Now isn’t it much easier to multiply your gross income by 20 than to fill in one of those online calculators? I thought so. Let’s move on.

5. The insurance rule:

You should have a policy equal to at least five to eight times your annual income as a minimum.

Some planners even suggest more than five to eight times your annual income as the level of cover you should carry. My suggestion is that you get your financial house in order, which means getting your net worth and cash flow statement together, and go talk to a good insurance agent about your needs.

He or she will be able to guide you through the various options. Just like with a financial planner, ask them how they are compensated to be honest with the advice they give you.

Note that this factor or rule of thumb can be much higher, depending on the number of years of income you need to replace. The highest “factor” I’ve seen is to multiply your annual after-tax income by 20.

Interesting that it is the same as the rule of thumb above. No coincidence here. If you were to die and want to ensure that your dependents would continue to receive exactly what you brought home each month, they would have to replace your income forever. According to the Twenty Factor Model, doing an insurance policy with at least 20 times your annual income.

6. The charity rule:

Give away at least 10% of your net pay every month.

Most of us think that there is not enough money to go around. We live in a state of scarcity rather than a state of abundance. We think that if we give away ten percent of our income annually, we won’t be able to live with it or pay a decent pension.

I understand the fears, but if you put the previous five rules of thumb in place, you shouldn’t worry too much about making ends meet. Let me explain.

Journalist Scott Burns, in his article titled, “Look Back” analyzed the amount of money you would need to save to avoid running out of money by the time we die, assuming we retire on the age of 65. The conclusion was that we should save 34 percent of our income if we planned to live for another 20 years after retirement. The analysis assumed that we would not earn a return on our investments.

But you will earn something on your investments, right? Of course you want to. Burns goes on to show that the higher the return on investment, the less you need to save.

The 34 percent of income that young people today must save if they earn no return falls to 25 percent if they earn the historic 2 percent real return from bonds.

It drops to 15 percent when they earn the 5 percent real return that a 60/40 stock/bond portfolio is likely to earn.

It falls to 9 percent of income when they earn the 7 percent real return of common stocks.

You already set aside 10% of your money (Pay Yourself First Rule of Thumb) and once you pay off your short-term debts, you will have an additional 20% of your salary free to invest wisely. Actually, if you put money aside tax-deferred, you put more than 10% of your net pay to each pay period, but why split rents.

In short, you have more than you think.

Give a little away and see how little impact it will have on your standard of living. Of course, you’ll feel better about yourself and you’ll help others in the process. No wonder it’s my favorite rule of thumb.

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