Rules of thumb can be helpful starting points for determining your finances. While they don’t have to be followed precisely to the letter, rules of thumb have been created for a reason: they’re proven to be effective. Here we’ll take a look at eight rules of thumb you should know for your financial life.
1. 50/30/20 Rule
For this rule, the first 50% of your monthly income goes to the recurring necessities of life, such as food, housing, and utility bills. The next 30% can go to the fun stuff that you want but don’t necessarily need, like entertainment and going out to dinner. And the last 20% is applied to financial goals, like saving for retirement, and putting away money in an emergency fund.
This rule isn’t perfect. If you already have recurring living expenses, they might add up to over 50% of your monthly income. If so, you may want to cut back on the entertainment expenses to ensure that you’re staying on track with your savings.
The 50/30/20 rule is best applied when planning to make decisions in advance. It can help to keep you from becoming house poor and put your financial future on solid ground.
A variation of the rule is the 80/20 rule, where 20% still goes to saving and investing, while the remaining 80% pays for everything else.
2. Buying a House: The Three-Year Rule
One of the ways you can ensure that you don’t become house poor is using the three-year rule. This rule states that you should not buy a home that costs more than three years’ worth of your annual income. You might notice a friend buying a house that you’re sure costs more than three years’ worth of their income, but your friend probably isn’t following this rule.
To not get stuck living paycheck to paycheck because of your housing costs, it can be wise to follow this rule to ensure that your house doesn’t cost more than you can afford.
3. Buying a Car: The Ten-Year Rule
You’re probably familiar with the adage that as soon as you pull your new car off the dealer’s lot, the value of the car plummets. For this reason, many people will suggest buying a car used, rather than new, to save on the depreciation hit your vehicle takes.
But if you want to buy something new, you should keep your car for at least ten years. And if you’re happy keeping your car even longer, then go for it. The longer you can keep your vehicle, the more value you receive for your initial investment, and the less the depreciation will matter when it’s time to sell your car. It also makes sense to put off adding a car payment and debt to your ledger for as long as you can.
Of course, this rule only works for cars that can reasonably last at least ten years. If you have a car that you are continually bringing in for service, it’s probably time to cut bait and move on.
4. The 10-15% Rule
The 10-15% rule states that you should be saving 10-15% of your income for retirement. This is more of a guideline than a rule because the number varies. At a minimum, though, you should be putting away 10% of your income to have enough money to retire on. Some suggest saving 15% while others suggest as high as 20%.
This rule doesn’t consider if you’re playing catch up with your savings, or if you already have savings in reserves. Go ahead and modify the number to fit your situation.
5. The Emergency Fund Rule
Everyone needs to have an emergency fund in place as the starting point for their financial savings strategy. The rule of thumb when it comes to an emergency fund is that you should have three months’ worth of living expenses stashed away at a bare minimum. Some suggest that you ultimately save up to six months’ worth of essential expenses in your emergency fund.
6. The Balanced Portfolio Rule
Having a balanced portfolio is an investment term for managing risk exposure in your portfolio. A well-balanced portfolio will continually succeed over time because it’s not outweighed in any one asset class. Some investments are higher risk and higher reward, while others offer low risk but limited upside. Stocks are typically more volatile but have higher rates of returns than bonds, which steadily earn a smaller amount.
To know the right balance, you can use this simple rule of thumb for a balanced portfolio.
The old rule of thumb used to take 100 and subtract it from your age to find out how much of your portfolio should consist of stocks. For example, if you’re 25 years old, you should have 75% of your money invested in stocks, and the other 25% on something more conservative.
With people living longer, you need your money to grow to a more substantial amount. So the new rule is to take 120 and subtract it from your age to determine the percentage of your portfolio that should be invested in the stock market.
7. The 1% Rule
A smart way to budget is to use sinking funds, which are individual funds that you set aside each year for various unexpected expenses. One of the most expensive of these is house maintenance. Whether it’s your dryer making noise or a roof that needs repair, these expenses can total in the thousands of dollars. So the 1% rule states that you should save 1% of your home’s value each year and set it aside in a separate account. If you don’t end up using the money, you now have a nest egg for remodeling expenses down the road, which will improve your home’s value when it comes time to sell.
8. The Financially Free Rule
This rule is the most fun of all if it applies to you. To figure out if you can retire early, calculate your current annual expenses and multiply them by 25. If the resulting number is less than the amount of money you have saved up, you are officially financially free and can retire in comfort.