Some Good Financial Rules Of Thumb

Some Good Financial Rules of Thumb

Rules of thumb can be a good approximate guideline for decisions, and there are lots of money rules that aim to get your finances on track. While everyone's situation is different, these serve as a good starting point.

We thought we'd put together a list of some solid, useful rules of thumb to follow. However, since everyone's situation is different, we've also included some scenarios in which these rules are worth reworking to your needs.

Budgeting

The 50/30/20 Rule

This is a popular rule for breaking down your budget. The 50-30-20 rule puts 50 per cent of your income toward necessities, like housing and bills. Twenty per cent should then go toward financial goals, like paying off debt or saving for retirement. Finally, thirty per cent of your income can be allocated to wants, like dining or entertainment.

There are also variations to this rule, like the 80-20 rule, in which you use 20 per cent of your income for financial goals, then spend 80 per cent on everything else.

Why It Works: If you're not sure where to start with a budget, breaking it up into these basic categories can be really helpful. Those percentages help create a balance between obligations, goals and splurges.

When It Doesn't: You might have trouble with this if you have a hard time separating needs from wants, even with something like housing. If you live in a low-cost area, 50 per cent toward housing and bills might be a lot. On the other hand, if you're not earning much, you might not have the luxury of only spending half your income on necessities.

These rules of thumb are good starting points for your spending. But maybe you want to adjust them, or make a budget that's more tailored to your situation. In that case, start from scratch, and design something that works best for you.

Buying A Vehicle

The 20/4/10 rule

When buying a car, you should put down at least 20 per cent. You should finance the car for no more than four years and spend no more than ten per cent of your gross income on transportation costs.

Why It Works: It keeps you from buying more vehicle than you can afford. It also takes your ongoing budget into consideration by calculating total transportation costs. These costs include not only your car payment, but also your gas and insurance, which can vary by vehicle type.

When It Doesn't: Depending on your situation, these numbers might not be realistic for you. For example, you may have a long, gas-guzzling commute at a low-paying job, making your transportation costs more than 10 per cent. On the other hand, if you've got the cash, you might choose to pay for your car upfront rather than take on a loan with interest. In that case, the rule wouldn't apply to you.

The 10-Year Rule

This rule has to do with the decision to buy new versus used. If you want to maximise your car's value, you should either buy used, or buy new and drive the car for ten years.

Why It Works: The rule minimizes your depreciation hit. If you buy a car that's a few years old, the depreciation will have already been sucked out of the vehicle. If you buy a new car and keep it for a decade, you'll have optimised its value and the depreciation won't matter as much.

When It Doesn't: Rather than put a timeline on it, some people prefer to drive their cars into the ground, whether they're new or used. The rule also doesn't consider the type of car. Some cars may last well beyond ten years; some may become a financial and maintenance headache after six years. Make sure your maintenance costs are worth it once you get near the end of the car's life.

You definitely don't want to spend more than you can end up paying for your car. And these rules help make sure you're on track with that. But research is important in considering all the variables.

Homeownership

The 20 Per Cent Rule

You should put at least 20 per cent down when buying a home, according to this rule.

Why It Works: It ensures you don't spend more home than you can afford, it can lower your monthly mortgage cost, and it can increase your chances of being approved for a loan. You also won't have to pay Private Mortgage Insurance.

When It Doesn't: While this is pretty traditional advice that's a safe bet, opinions vary. Some consider it an overwhelming amount to save, especially given modern prices. Some argue that, while a home is an asset, you shouldn't give up your liquidity, or savings. Of course, there are counterarguments to be made, but the point is: some consider the rule unrealistic.

The Income Rule

Don't buy a house that costs more than three years' worth of your gross annual income. Some variations say no more than two years; others say two and a half.

Why It Works: It puts a ballpark limit on how much home you can (or should) afford.

When It Doesn't: Maybe your job is volatile. This rule doesn't consider how much money you have in reserves, in case something should happen with your income source. It might make more sense to consider your net worth rather than your income. It also doesn't consider house prices where you want to live.

Again, these general rules serve a purpose: they give you an approximate amount to start with when thinking about homeownership.

Retirement

The 10% Rule

This is probably the most traditional rule of thumb when it comes to saving for retirement. Save ten per cent of your income toward retirement.

Why it works: It gives people a simple number to work with. If you're not sure how much of your earnings to set aside on top of superannuation, 10% is a good start.

When it doesn't: While simple, the percentage doesn't consider how much you'll actually need in retirement. It also doesn't consider how much you've currently saved. If you're playing catch-up, you'll probably need to save considerably more than ten per cent of your income. If you want to retire early, or more lavishly, you'll probably need to save more than ten per cent.

The Income Rule

Here's another rule of thumb for deciding how much to set aside for retirement. You should save 20x your gross annual income.

Why It Works: It actually focuses on what you'll need in the future.

When It Doesn't: Your retirement expenses might differ from how much income you earn now. Depending on the lifestyle you plan to live, you may need a lot more, or less, than your income.

Saving and Investing

The 6-Month Emergency Fund Rule

You should have six months' worth of savings on hand in case of an emergency.

Why It Works: Obviously, this is a big help in case an emergency arises in your life. It keeps you from having to make desperate decisions that can set you back.

Why It Doesn't: There are so many different opinions on how much you should have saved. Some say between 3-6 months; others say there are times when an emergency fund is unnecessary altogether. There's also the argument that, by keeping so much money in a low-to-no interest savings account, you're missing out on a potential return.

We've said it before, but ultimately, you have to decide what works best for you. You can tweak the rule based on a number of variables, including:

  • Income
  • Different types of emergencies that may arise for you
  • Net worth
  • Your monthly expenses

If you're in emergency mode, you'll probably also pare down your monthly expenses, so consider that in your decision too.

Most of these rules are solid, tried-and-true methods for planning your finances. But again, personal finance is, well, personal. These rules are a good starting point, but to really stay on top of your finances, research and personalised planning is a necessity.


Comments

    For retirement, rather than super + 10% as mentioned above, I go to salary sacrifice so that my contributions match half my age.

    eg. if i am 30 then I add 5.5% to the current 9.5%. As a 50 year old I would add 25% which may be a SG of 12.5 and salary sacrifice only 12.5%.

    That way you are building up incrementally and don't notice the change each year as much.

    2-3 times income for a house, eh?

    Average Australian income: $72,800 (http://mattcowgill.wordpress.com/2013/05/13/what-is-the-typical-australians-income-in-2013/). Median is $53,000 or so.

    Suggested house price: 3 x $72,800 = $218,400.

    Median house price in Sydney: $800,000 (http://news.domain.com.au/domain/real-estate-news/sydneys-median-house-price-pushes-through-800000-20140723-zvxjw.html)

    Good luck with that. I'm not saying it's not a sensible piece of financial advice, but there's not an awfully large number of people following it (unless the average Sydney homeowner is sitting on an income of $260,000, which seems a little fanciful).

    3 years gross annual income? That wouldn't work in this day and age. You'd have to go at least 5 - 6 years instead. Though it would probably explain why the housing is so expensive in this country.

    The income rule on Houseownership - 2~3yrs worths of gross annual income...
    what was the median house price in sydney last time you checked? haha...

    Usually a couple would purchase a house, meaning you can double that amount. $520,000 is realistic.

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