9 Handy Financial Rules of Thumb

A rule of thumb is a general guideline, an easy way to approximate a value quickly. But it's not meant to be completely accurate.

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Lately I’ve found myself using more and more financial rules of thumb. A rule of thumb is a general guideline, an easy way to approximate a value quickly. But it’s not meant to be completely accurate.

For instance, one standard financial rule of thumb is to save at least 10% of your income. A better goal is to aim for 20%. At MSN Money, Liz Weston once suggested that if you’re young, you can follow this rule of thumb: “Save 10% for basics, 15% for comfort, 20% to escape.”

Sometimes experts will agree on a general rule of thumb, but not on specifics. For instance, nobody agrees how much you should set aside for an emergency fund. Financial gurus offer advice ranging from $1,000 up to 12 months of expenses. (The most common suggestions range from three to six months of expenses.) However, one clever guideline is that your emergency fund should cover X months of expenses, where X is the current unemployment rate. (In other words, because the U.S. unemployment is at 7.9% right now, you should aim to have enough money in the bank to cover eight months of expenses.)

Another rule of thumb is that over the long term, the stock market averages about a 10% annual return. But remember: average is not normal. Also, many experts (including Warren Buffett) expect stock returns to be lower over the next few decades.

For years, another rule of thumb was to have X% of your portfolio invested in stocks, where X is equal to 100 minus your age — with the rest invested in lower-risk investments like bonds. (Thus, if you’re 30, you should have 70% invested in stocks and 30% in bonds.) During the 1990s and 2000s, “experts” began to play with that formula, with some gurus recommending as much as 140 minus your age invested in stocks. With this guideline, I’d be 100% invested in stocks right now. That’s dumb. With the market turmoil over the past few years, the more traditional “100 minus your age” rule has once again become more popular.

When lenders calculate how much house a borrower can afford, they use the debt-to-income ratio, a measure of how much of your income goes toward debt. These lending guidelines also crept upward during the 1990s and 2000s. I’m a strong advocate of being conservative here. I believe your housing costs should be less than 28% of your gross income, and your total monthly debt payments should be less than 36%. These numbers provide ample room but prevent borrowers from being trapped by too much debt.

After your home, your car is probably your biggest expense. One common rule of thumb when purchasing a car is to buy used, or to buy new and to drive it for 10years. Either one will save you big money. (Do both and you’ll save even more.)

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Here’s another rule of thumb from Liz Weston: To approximate a new vehicle’s five-year cost of ownership (in monthly terms), double the price tag and divide by 60. And remember the advice of Tom and Ray, the Car Talk guys: It almost always makes more financial sense to repair your car than to buy a new one.

When it comes to retirement, the standard advice is to aim to replace 80% of your pre-retirement income. This rule is lame because it focuses on income and not expenses. Income is irrelevant. It’s what you spend that matters. Instead, I recommend a different rule of thumb: Base your retirement needs on 100% of your pre-retirement expenses — plus 10%.

Another approach to retirement savings says that you’ll need to save about 20x your gross annual income to retire. In other words, if you earn $50,000 per year, you’ll need $1,000,000 to retire. Again, I think this is lame because it focuses on income and not expenses, and expenses are what matter. But still, this can be a handy gauge.

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:

  • Pay yourself first. Set aside your savings every month before you use the money for other things, including bills.
  • 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. (Note that under normal conditions, home values appreciate slowly, so they’re not included in this guideline.)
  • 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.
  • If you’re not willing to pay cash for it, then it doesn’t make sense to buy it on credit.

What about you? What financial rules of thumb do you use when managing your money?

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