Financial Rules of Thumb: The Useless and the Useful

I like rules of thumb. They provide helpful shortcuts for making quick calculations and decisions. You don’t always have time (or want to take the time) to create elaborate spreadsheets when choosing a course of action. In these cases, it’s nice to have some rough guidelines you can rely on.

During our recent RV trip across the United States, for instance, Kim and I developed a handful (ha!) of rules of thumb to help us plan our adventures. For instance:

• Over long distances, we moved at a rate of 50 miles per hour. If our GPS said it’d take four hours to travel the 300 miles to Dubuque, we ignored it. We knew it’d take us about six.
• We burned one tank of gas every 350 miles, which meant we got about seven miles per gallon. (We actually averaged 7.8mpg, but our rule of thumb gave us a buffer.)
• We estimated it cost us $50 per day for necessities (gas, food, lodging). Basic tourism (cheap restaurants, local museums) cost an extra $25 per day. Deluxe tourism (nicer restaurants, concerts or shows) raised expenses to $100 per day.

These rules of thumb weren’t precise. Nor did they always hold true. But they were true enough for us to make loose plans based on them.

There are lots of rules of thumb in the world of personal finance. With so many numbers and calculations, quick shortcuts not only save time but also help make abstract concepts more accessible.

You’ve probably heard of the “rule of 72”, for example. This shortcut says that if you divide 72 by a particular rate of return, you’ll get the number of years it’ll take to double your money. If your savings account yields 4%, say, it will take about 18 years for your nest egg to increase by 100%. But if you were able to earn 12% on your investment, that money would double in six years.

Like all rules of thumb, the rule of 72 isn’t precise. It doesn’t give an exact answer but a ballpark figure. I have some engineer friends who’d get tense at this sort of sloppy guesswork, but most of the rest of us are happy to trade a bit of precision for speed. That’s what rules of thumb are all about!

The trick, of course, is knowing which rules of thumb to use. Most are handy, but some common guidelines do more harm than good.

Rules Gone Wild

On Friday, I ranted about one of my most-hated financial rules of thumb: the idea that you should base your retirement savings on 70% of your income. “Instead of estimating your retirement needs from your income,” I wrote, “it makes far more sense to base them on spending. Your spending reflects your lifestyle; your income doesn’t.

I think a better rule of thumb for determining retirement needs is this: When estimating how much you’ll need to save for retirement, assume you’ll spend as much in the future as you do now. Use 100% of your current expenses to calculate your retirement spending. (And if you want to build in a safety margin, base your future needs on 110% of your current spending.)

Another rule of thumb that makes me cranky is this common guideline espoused by all sectors of the homebuying industry: “Buy as much home as you can afford.” No no no no no! Of all financial rules of thumb, this is probably the worst. It’s certainly one of the most prevalent. This is how folks end up house poor, chained to a mortgage they resent.

Lenders quantify this guideline by saying your housing payments should be nor more than 28% or 33% or 41% of your income. But, as David Bach wrote in The Automatic Millionaire Homeowner, “You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow.” A better rule of thumb? Spend as little on housing as possible. Spending less than 25% of your net income is best — less than 20% is even better.

A third rule that bugs me is the one for determining how much life insurance you should buy. Different experts give different answers. Some say your policy should cover five times your annual income. Others say ten times. And Suze Orman recommends 20 times annual income needs.

The truth is that not everyone needs life insurance. Like all insurance, it’s designed to prevent financial catastrophes. You only need it if other people — like a spouse or children — would face financial hardship when you die. If you don’t have kids, if your spouse has a good income, or you have substantial savings, then life insurance isn’t a necessity.

Even if you do need life insurance, you probably don’t need to carry as much as your insurance agent is willing to sell you. To find out the amount that’s right for you, check out the Life Insurance Needs Calculator from the non-profit Life Happens organization. (How much life insurance should I carry? According to this calculator, I shouldn’t have any at all. And I don’t.)

A Few of My Favorite Rules

Financial rules of thumb usually aren’t this bad. In fact, most are useful. Here are a few of my favorites.

• When estimating income, $1 an hour in wage is equivalent to $2000 per year in pre-tax earnings. The reverse is also true: $2000 per year in salary is equal to $1 an hour in hourly wage. (This rule works because the average worker spends roughly 2000 hours per year on the job.)
• I hate detailed budgets because they bog people down. Instead, I’m a fan of budget frameworks that focus more on the Big Picture. My favorite budget framework is the Balanced Money Formula: Spend no more than 50% of your after-tax income on Needs, put at least 20% into savings (including debt reduction), and spend the rest (around 30%) on Wants. This is a great beginner budget, but it’s also useful for transitioning to the mindset of Financial Independence. If you decide early retirement is a goal, then part of your Wants spending becomes additional savings.
• How wealthy should you be? According to the authors of The Millionaire Next Door, the following “wealth formula” can tell you if you’re on target: Divide your age by ten, then multiply by your annual gross income. Your net worth should be equal to this number (less any inheritances). So, if you’re 40 and make $50,000 per year, your net worth should be $200,000. If you have less than half the expected amount, you’re an “under-accumulator of wealth”. If you have twice the target, you’re a “prodigious accumulator of wealth”. (Note that the authors are well aware that this formula doesn’t work well for young people; it’s meant to be used by folks nearing retirement age.)
• On average, each dollar an American spends represents about $2.50 of after-tax value in ten years or $10 in thirty years. (If you live outside the U.S., the consequences of spending that dollar are probably even greater.) This is due to two reasons: taxes and compounding. When you buy something, you spend after-tax dollars. On average, Americans have to earn $1.33 to have $1.00 left over.
• Inflation is the silent killer of wealth. In the U.S., inflation has averaged 3.18% over the past hundred years. A lot of folks figure a 3% inflation rate when making money calculations. I think it’s safer to assume 3.5% — or even 4% — average inflation in the future.
• Historically, U.S. stocks have earned long-term real returns (meaning inflation-adjusted returns) of about 7%. Bonds have long-term real returns of around 2.5%. Gold and real estate have long-term real returns of close to 1%.
• If you withdraw about four percent of your savings each year, your wealth snowball will maintain its value against inflation. During market downturns, you might have to withdraw as little as three percent. If times are flush, you might allow yourself five percent. But four percent is generally safe. (For more on safe withdrawal rates, check out this article from the Mad Fientist.)
• Based on the previous rule of thumb, there’s a quick way to check whether early retirement is within your reach. Multiply your current annual expenses by 25. If the result is less than your savings, you’ve achieved financial independence — you can retire early. If the product is greater than your savings, you still have work to do. (If you’re conservative or have low risk tolerance, multiply your annual expenses by 20. If you’re aggressive and/or willing to take on greater risk, multiple by 20.)
• Building on the above, Mr. Money Mustache’s shockingly simple math behind early retirement gives us a useful rule of thumb for determining how long you’ll need to save before you’re financially independent. Figure out your current saving rate (or profit margin, if you prefer). Subtract this number from 60. Roughly speaking — and assuming you’ve started from a zero net worth — that’s how long you’ll need to work before your nest egg is big enough to support you in retirement. (Note that this rule breaks down at saving rates over 40%. If you save a lot, subtract from 70.)
• If you own your home, it’s wise to set aside money for maintenance and repairs. Each year, contribute 1% of your home’s current value to a separate account. If you don’t spend the money, keep it there for future remodeling and improvements.
• Is it better to buy or to rent? The price-to-rent ratio is a useful rule of thumb for making this decision. Find two similar places, one for sale and one for rent. Divide the sale price of the one by the annual rent for the other. The result is the P/R ratio. Say you find a $200,000 house for sale in a nice neighborhood, and a similar home for rent on the next block for $1000 per month, which is $12,000 per year. Dividing $200,000 by $12,000, you get a P/R ratio of 16.7. If the P/R ratio is low, it’s better to buy. If the price-to-rent ratio is over 20, it’s probably better to rent. (For more info on price-to-rent ratios, check out this terrific article from SmartAsset.)
• How much does it cost to raise a child? As a rule of thumb, budget $10,000 per child per year. That’s not quite a quarter of a million dollars per kid, but it’s close.
• If you get a windfall, use 1% to treat yourself. (Or maybe 2%, tops.) Put the rest in a safe place and ignore it for six months. After you’ve had time to think about it, then take action. So, if you inherit $100,000 from Aunt Marge, only allow yourself a $1000 splurge. Stash the remaining $99,000 someplace you won’t be tempted to spend it.

It’s important to remember that rules of thumb aren’t set in stone. They’re guidelines. They’re meant to help you make quick evaluations, not actual life-changing decisions.

“I see financial rules of thumb as a starting point,” wrote Miranda Marquit (Planting Money Seeds, the Adulting podcast) when I polled the Money Boss group on Facebook yesterday. “I start with them, and then adjust for my individual goals and situation.”

Other Guidelines

Strictly speaking, rules of thumb deal with numbers. Still, there are a lot of non-numeric guidelines that I think are useful to know. Here are a few:

• The more you learn, the more you earn. In the U.S., education has a greater impact on work-life earnings than any other demographic factor. Your age, race, gender, and location all influence what you earn, but nothing matters more than what you know.
• Bank a raise. When you get a salary bump, don’t increase your spending. Stay the course and put the added income into savings.
• Always take the employer match on the 401(k).
• Never touch your retirement savings — except for retirement.
• Never co-sign on a loan.
• Avoid paying interest on anything that loses value. It’s okay to finance a home or a college education but avoid taking out a loan on a car.
• Don’t mess with the IRS. When it comes to taxes, don’t try to cheat. Pay what you owe. Claim all the deductions you deserve, but don’t try to stretch things.
• In general, save an emergency fund first; pay off high-interest debt second; and begin investing (at the same time you pay down remaining debt) last.
• It almost always makes more sense (and cents) to repair your old car than to buy a new one.
• If you’re not willing to pay cash for it, then it doesn’t make sense to buy it on credit. (I have a friend whose guiding principle is: “If I wouldn’t buy five, why would I buy one?” Similar idea taken to an extreme.)

Now it’s your turn. What rules of thumb did I miss? Do you disagree with any of those I suggested? What are some of your favorite rules of thumb?

from Money Boss http://ift.tt/2asyXqc