Although not hard and fast, rules of thumb can be quite helpful in making decisions and achieving goals. You may have rules of thumb for finding a job or going to the grocery store. How about financial rules of thumb? These will help you manage your money and reach your financial goals.
Basics
If you’re the type of person who spends money as soon as it comes in, you’ll benefit from this one. Pay yourself first! This means as soon as money comes in, put at least a little in your savings account. You can automate this to ensure it gets done; that way, you’ll never be tempted to spend it on something else.
Assuming you’re living comfortably, put that extra money in your savings account any time you get a raise. This will prevent lifestyle creep, blowing up your expenses with unnecessary luxury items.
Broken appliances are a considerable annoyance. When it happens, get a quote from a qualified repair person. If it’s 50% of the cost of the new one and the appliance is more than eight years old, it’s time to invest in a new one. It may seem frivolous, but newer appliances are less likely to require additional investment to keep them running.
Have an unexpected money windfall? That’s exciting! Use a small percentage to treat yourself. Put the rest in the bank and think about the best use for it.
Budgeting
For most people, the 50/30/20 rule works well. With this, 50 percent of your income goes to necessities like housing and food, 30 percent goes to “wants” such as dining out or seeing a show, and 20 percent goes towards reaching financial goals such as saving for retirement or paying off debt. This creates a workable balance in most situations that better presents needs, wants, and long-term goals.
If you’re not all about spreadsheets, a super detailed budget may not be right for you. However, you should at least track your problem spending area. Maybe you know you spend a lot on eating out or clothes. Keeping track of those items will help you stay on track with your entire budget.
Food is essential, but it doesn’t have to eat up your entire budget- Plan for about 10% to 15% of your monthly expenses to go towards food. This includes groceries and dining out.
Haircuts, spa days, clothes, and other personal expenses are also important. They should make up about 8% of your budget and are also a great place to cut back if money is tight.
Buying a Car
Other than a house, for most people, buying a car is their biggest expense. Assuming you have a reasonable commute and a decent-paying job, the 20/4/10 rule is the way to go. Put down 20% of the cost of the vehicle and finance the rest for no more than four years. You should aim to spend no more than 10% of your gross income on transportation. In most situations, this ensures you don’t buy more car than you can afford.
In general, buying a new vehicle isn’t a sound financial investment. But if you plan to drive the car for at least ten years, it can make sense.
As you know, owning a car has other costs associated with it, such as insurance and maintenance. To estimate how much it will cost to own the car for five years, double the price tag (not the price you pay) and divide by 60. A $10,000 car costs about $333 per month.
Cars are depreciating assets, meaning they lose value over time. So, to ensure you don’t spend too much of your hard-earned money on something that will never increase in value, limit your spending to 20% of your take-home pay for all costs on all vehicles you own.
College
It sounds counterintuitive, but you should save for your retirement first and your children’s college tuition second. Remember, your kids can borrow money for college. You can’t borrow money for your retirement.
If you’re a student, limit your student loan amounts to the value of your anticipated first year’s salary. This way, you’ll be able to pay them off without too much stress.
Buying a Home
This one is a big deal – and a big commitment. Most people own their homes for at least five years. To help avoid added costs such as PMI, put down at least 20% of the purchase price. In addition to keeping your mortgage costs lower, it also helps ensure you don’t sign up for a bigger mortgage than you can handle.
Another way to limit yourself to buying a home you can afford is to purchase a home that costs no more than 2.5 to 3 times your gross annual income. If you’re buying when interest rates are high, or you know the property taxes will be a lot, consider going with two times your gross annual income instead.
If interest rates drop by more than 1% of where they were when you bought your house, it might be time to refinance.
If you’re looking for a variable-rate mortgage, be careful. They may make sense if you only plan to live there for a few years, assuming the rate will remain the same the entire time you own the property.
If you’re getting a reasonable rate, pre-paying your mortgage isn’t worth it. Use that money to achieve other financial goals instead.
Retirement
No one wants to work forever. Unless you’re nearing retirement age, putting 10% to 20% of your income towards retirement is a simple number to work with and ensures money is regularly being set aside.
Another way to figure out how much to set aside for retirement is to work backward. You should set aside 20x your gross annual income. Thinking about it this way gets you focused on the future and helps you back into how much you need to set aside with every paycheck.
You can determine how much of your portfolio to invest in stocks by taking your current age and subtracting it from 100. For example, if you’re 40 years old, you should invest 60% of your retirement portfolio in stocks.
Does your employer offer matching funds for retirement investments? If so, you should always take advantage of it. It’s basically free money for your future.
This retirement calculator can help you determine how much you need to invest.
Saving and Investing
Emergencies happen. To protect yourself from financial disaster in the case of a crisis, aim to have at least 6-months of income readily available. Although having so much money in low-interest accounts can feel like a missed opportunity, you’ll breathe a sigh of relief if you need it quickly.
Figure out how long it will take your investments to double. This isn’t as hard to do as you’d think. It’s called “the rule of 72.” Take 72 and divide it by the interest percentage you’re earning (say 10% for easy math). In this example, your investment will take 7.2 years to double. If you’re earning 5% interest, your investment will take 14.4 years to double. Ideally, you should shoot for your investments to double every ten years.
Insurance
Life insurance helps protect your family. Having 5 to 6 times your gross annual salary in life insurance is generally recommended. You may want to opt for more if you have multiple children, high amounts of debt, or other special situations. Dave Ramsey says to get coverage that’s equal to 10-12 times your annual income. And make it a level-term life policy that lasts for 15-20 years. So what’s the correct answer? Here’s a rule of thumb that can help – The DIME Method. DIME is an acronym for Debt, Income, Mortgage, and Education expenses.
Whether it’s car insurance, homeowners insurance, or another coverage, it’s best to keep those policies for catastrophic situations. While your car insurance may pay to repair your windshield crack, it’s usually a fairly inexpensive item. Paying for it out of pocket will keep your insurance costs lower.
Paying Off Debt
No more than 30% to 35% of your income should go towards paying the minimum debt payment amounts, including mortgage (or rent if you don’t have a mortgage).
Determine which of your debt payments has the highest interest rate and aim to pay that off first. Long-term, it will save you the most money. You may also consider using a 0% interest balance card to reduce your payments.
Although these rules of thumb don’t work for every financial situation, they’re a good starting point, especially if you struggle to figure out a money management strategy.
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