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6 Financial Rules of Thumb
I wonder how many of you are big-time readers. You know, those people who can read a book a week or sift through endless reams of data and advice to help them develop a financial plan that will put them on the path to prosperity.
However, if you’re like most people and don’t have the time (or the inclination) to read a mountain of books, magazines, and web sites, then this article is for you. It will list key “rules of thumb” for financial planning.
1. Saving/Investing Rules of Thumb:
Pay yourself first: Aim to set aside at least 10% of your take-home pay
I’m sure you’ve seen this rule before. I first read it in The Richest Man in Babylon. As you’ll learn, paying yourself first is the most important bill you’ll pay each month.
The best way to enforce this rule is to automate it. Deduct 10% of your take-home pay from your paycheck and deposit it into a separate bank account. If your employer doesn’t allow you to do this, set up a transfer equal to ten percent of your paycheck between your main account and your “ten percent” account.
If you already have a well-funded emergency fund and your short-term goals are funded, you can funnel all ten percent into a retirement plan. Of course if you set aside 10% in your retirement plan, you will make a pre-tax contribution that will exceed the 10% after-tax.
2. Short-Term Loan Rules 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 need to list all your outstanding obligations and their respective minimum/monthly payments. Now add the minimum/monthly payment amounts and you come up with a figure.
Take this number and divide it by your monthly take-home pay.
If the result is more than 20%, you are carrying too much revolving debt. New entrants to the workforce or recent graduates often have high debt-to-income ratios due to their student loans and low-paying entry-level jobs.
Compulsive spenders also have problems because they spend every dollar they make.
You should aim to set aside at least 20% of your net salary to pay off your outstanding debt. If you stop adding to your short-term loans today, you could pay off most of your short-term loans in anywhere from 3-7 years.
3. Housing Cost Rules of Thumb:
You should spend less than 36% of your monthly salary on housing
This rule is mainly for landlords, but if you’re renting and spending more than 36% of your monthly salary, you’re either living in NYC or San Francisco and it’s time to find a new place. Either that or find another roommate.
Well, banks want to see that your monthly mortgage payments, taxes, insurance, and the cost of utilities aren’t putting an unnecessary burden on your finances.
In short, they calculate the cost of living in your home and know that if you’re paying more than 36% for your housing costs, you’ve probably bitten off more than you can chew.
Whatever your current percentages are, aim to lower these percentages over time. Just because a bank is willing to lend you up to 28 percent of your gross monthly income, doesn’t mean you have to borrow a lot of money to buy a home.
The less money you borrow, the faster you can pay it back and the higher your monthly cash flow will be (because you’re spending less on your mortgage). The less you spend monthly, the more you have to invest for your future.
4. Retirement Rules of Thumb:
You need to save about 20 times your annual gross income to retire
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’ve never met anyone with the patience to fill one of these out and they only take two minutes to complete! The solution is what author Robert Sheard calls the Twenty Factor Model.
Basically the formula is:
Financial Independence = Annual Income Requirement X 20
This formula is based on two centuries of stock market returns and the real rate of return (5% per annum) you could earn after taxes, expenses and inflation.
If you have 20 times your annual income requirement, that means with a fixed withdrawal rate of 5% per year from your nest egg and an annual expected net return on your investment of 5%, you will never run out of money.
Now isn’t multiplying your gross income by 20 much easier than filling out one of those online calculators? I thought so. Let’s move on.
5. Insurance Rules of Thumb:
You should have a policy worth at least five to eight times your annual income as your minimum.
Some planners recommend five to eight times your annual income as the level of coverage you should carry. My suggestion is that you get your financial house in order, which means get your net worth and cash flow statement together, and talk to a good insurance agent about your needs.
He will be able to walk you through the various options. As a financial planner, ask them how they are compensated to be honest with the advice they give you.
Please note that this factor or rule of thumb may be much higher, depending on the number of years of income you need to replace. The highest “factor” I’ve seen is multiplying your annual after-tax income by 20.
Interestingly, this is the same rule of thumb. No coincidence here. If you were to die and want to make sure your dependents continue to receive exactly what you brought home each month, they would need to replace your income in full forever. According to the twenty factor model, have an insurance policy of at least 20 times of your annual income.
6. The Charity Rule of Thumb:
Give at least 10% of your net salary every month.
Many of us feel that there is not enough money to go around. We live in a state of scarcity instead of abundance. We think that if we give away ten percent of our income each year, we probably won’t be able to make ends meet or afford a decent retirement.
I understand the fear, but if you keep the previous five rules of thumb, you won’t have to worry too much about making ends meet. Let me explain.
In his article, “Look at Returns,” journalist Scott Burns analyzed the amount of money you’d need to save to make sure we don’t run out of money by the time we die, assuming we retire at age 65. It concluded that if we plan to live another 20 years after retirement, we should save 34 percent of our income. The analysis assumed that we would not earn any return on our investment.
But you will earn something on your investment, right? Of course it will. Burns shows that the higher the return on investment, the less you need to save.
If there is no return, the 34 percent of income young people need to save today drops to 25 percent if they earn a historical 2 percent real return.
This drops to 15 percent if they earn the 5 percent real return that a 60/40 stock/bond portfolio would earn.
If they earn a 7 percent real return on common stocks, this drops to 9 percent of earnings.
You are already setting aside 10% of your money (Pay Yourself First Rule of Thumb) and once you pay off your short-term debt, you will have an extra 20% of your salary free to invest wisely. In fact, if you’re setting aside tax-deferred money, you’re setting aside more than 10% of your net pay each pay period, but why split hairs?
In short, it’s more than you think.
Give a little away and see how much it affects your standard of living. Of course, you’ll feel better about yourself and you’ll help others in the process. No wonder this is my favorite rule of thumb.
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