6 General Financial Rules

I wonder how many of you are great readers. You know the type, the ones who can read a book a week or review endless data and tips to help them develop a financial plan to guide them on the path to prosperity.

However, if you’re like most people and don’t have the time to read a mountain of books, magazines and websites (or are inclined to), then this article is for you. It will list the main “rules of thumb” for financial planning.

1. The general savings/investment rule:

Pay yourself first: try to set aside at least 10% of your take-home pay

I’m sure you’ve seen this general rule of thumb before. I first read about it in The Richest Man in Babylon. As he will learn, paying himself first is the most important bill he will pay each month.

The best way to implement this rule is to make it automatic. Have 10% of your take-home pay taken from your paycheck and deposited into a separate bank account. If your employer doesn’t allow you to do this, simply set up a transfer between your main account and your “ten percent” account equal to ten percent of your paycheck.

If you already have a well-funded emergency fund and your short-term goals have been funded, you can funnel all of the ten percent into a retirement plan. Of course, if you set aside 10% in your retirement plan, you’ll be contributing before taxes, which works out to be more than 10% after taxes.

2. The short-term debt rule of thumb:

So-called “bad” debts must not equal more than 20% of your income

Short-term debt includes your auto and student loans, as well as your credit cards and other forms of debt. Essentially everything except your mortgage. You must list all your outstanding liabilities and their respective minimum/monthly payments. Now add up the minimum/monthly payment amounts and you’ll get a figure.

Take this number and divide it by your monthly take-home pay.

If the result is more than 20%, you have too much revolving debt. New to the workforce or recent graduates often have higher debt-to-income ratios due to their student loans and low-paying entry-level jobs.

Compulsive spenders also have a problem because they spend every dollar they earn.

You should aim to put at least 20% of your take-home pay toward paying off your outstanding debts. If you stop adding to your short-term debt today, you’ll find that you can pay off most of your short-term debt in 3-7 years.

3. The general rule of thumb for the cost of housing:

You should spend less than 36% of your monthly salary on housing

This rule of thumb is mostly for homeowners, but if you’re renting and spending more than 36% of your monthly payment on rent, you’re living in New York or San Francisco and it’s time to find a new place. Either that or find another roommate.

Why 36%?

Well, banks like to see that the cost of your monthly mortgage payment, taxes, insurance, and utilities don’t place an undue burden on your finances.

In short, they calculate the cost of living in your home and know that if it exceeds 36% of housing costs, you’ve probably bitten off more than you can chew.

Regardless of what your current percentages are, try to reduce these percentages over time. Just because a bank is willing to lend you up to 28 percent of your gross monthly income doesn’t mean you should borrow that much money to buy a home.

The less money you borrow, the faster you can pay it back and the higher your monthly cash flow will be (because you’re spending less on your mortgage). The less you spend monthly, the more you will have to invest for your future.

4. The general retirement rule:

You must save about 20 times your annual gross income to withdraw

There are plenty of calculators and spreadsheets online (I have one too) that you can use to figure out how much you’ll need to retire. I have never come across anyone who has the patience to complete one of these and it only takes two minutes to complete! The solution is what author Robert Sheard calls the Twenty Factor Model.

Essentially the formula is:

Financial independence = annual income requirement X 20

The formula is based on two centuries of stock market returns and the real rate of return (5% per year) you can expect to earn after taxes, expenses, and inflation.

If you have 20 times your annual income requirement, it means that with the prescribed withdrawal rate of 5% per year on your savings and the expected annual net return on your investments of 5%, you’ll never run out of money.

Now, isn’t it much easier to multiply your gross income by 20 than to fill out one of those online calculators? I thought so. Let’s go.

5. The general rule of insurance:

You must have a policy equal to at least five to eight times your annual income as a minimum.

Some planners even suggest more than five to eight times your annual income as the level of coverage you should have. My suggestion is to put your financial house in order, which means gathering your net worth and cash flow statement, and go talk to a good insurance agent about your needs.

He or she will be able to guide you through the various options. Just like with a financial planner, ask them how they are compensated so they are honest with the advice they are giving you.

Keep in mind that this factor or rule of thumb could be much higher, depending on the number of years of income you will need to replace. The highest “factor” I’ve seen is multiplying your annual after-tax income by 20.

It is interesting that it is the same as the previous general rule. There is no coincidence here. If he died and wanted to make sure his dependents continued to receive exactly what he brought home each month, they would have to completely replace his income forever. According to the Twenty Factor Model, it will be enough to have an insurance policy with at least 20 times your annual income.

6. The general rule of charity:

Give away at least 10% of your take-home pay every month.

Most of us think that there is not enough money to go around. We live in a state of scarcity instead of a state of abundance. We think that if we give away 10 percent of our income each year, we won’t be able to make ends meet or afford a decent retirement.

I understand the fears, but if you put the five rules of thumb above into practice, you shouldn’t have to worry too much about making ends meet. Let me explain.

Journalist Scott Burns, in his article titled “Take a Look at the Yields,” did an analysis of how much money you would need to save so that you don’t run out of money when you die, assuming you retire at age 65. The bottom line was that we would need to save 34 percent of our income if we planned to live another 20 years after retirement. The analysis assumed that we would not earn any return on our investments.

But you will earn something with your investments, right? Of course you will. Burns goes on to show that the higher your return on investment, the less you’ll have to save.

The 34 percent of income that young people need to save today if they earn no yield drops to 25 percent if they earn the historical real yield of 2 percent on bonds.

It drops to 15 percent if they earn the 5 percent real return that a 60/40 stock/bond portfolio is likely to earn.

It plummets to 9 percent of earnings if they earn 7 percent actual return on common stock.

You’re already saving 10% of your money (Pay Yourself First rule of thumb) and once you pay off your short-term debt, you’ll have an additional 20% of your salary free to invest wisely. In reality, if you’re setting aside money tax-deferred, you’re setting aside more than 10% of your take-home pay each pay period, but why split hairs?

In short, you have more than you think.

Give a little away and you will see how little impact it will have on your standard of living. Of course, you will feel better about yourself and you will be helping others in the process. No wonder it’s my favorite rule of thumb.

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