Financial rules of thumb can be limiting and many times don’t factor in the unique circumstance of each household. However, they do serve as good guidelines and benchmarks for comparing our progress with the ‘standard.’ They are also super helpful if you hate getting too detailed with your financial planning and want a general mark to shoot for.
When you place constraints on something as personal and dynamic as one’s personal finance, there are bound to be strengths and weaknesses that arise from these rules. This two-part post will review 10 popular financial rules of thumb and their strengths and weaknesses.
The 1/3 Rule (for Unexpected Income)
This rule applies only to unexpected income and is ideal for those not sure of what to do with this income. Without a plan in place, most of us will spend our windfall income on our immediate needs and wants and not really consider other options. This rule tells us to allocate 1/3 of our income to the past (debts and financial obligations), 1/3 to the present (monthly essential needs and wants like groceries, utilities, clothing etc.) and 1/3 to the future (saving for emergency, contingency fund or retirement).
A major strength of this rule is it puts in place a plan of action for income that would mostly likely be mismanaged. It also ensures equal distribution of efforts when dealing with our past obligations, immediate need and future goals. Those with no debts may wish to modify this rule and apply 1/ 2 to their present and 1/ 2 to their future. The key to remember is neither aspects of our lives are neglected and distribution is equal. Examples of windfall income include: tax refund, bonus, monetary gift etc.
The simplicity of this rule is also what makes it impractical for many people. Most people may not have the financial means to put 1/3 or 33.33% of their windfall income towards their future but may need much of these funds to take care of their immediate needs. I think this rule works best for those that live well below their means and have little debt.
20/4/10 Rule for Buying A Vehicle
This rule applies to those who finance their car purchase. If you purchased your vehicle with cash, then this rule does not apply to you.
This rule states that when financing a vehicle, you should put at least 20% down to purchase the vehicle. You should spend no more than 4 years to pay off the loan and spend no more than 10% of your income on transportation costs (including car payments, insurance, gas, maintenance & repairs).
Let’s say a family wanted to purchase a vehicle worth $20,000 (for simplicity this includes all taxes & fees). To abide by this rule, this family would need to have a down payment of $4,000 ($20,000 X 20%), leaving them with a loan of $16,000 to pay back over 4 years. If their annual interest rate is 4%, their expenses may be as follows):
|Down Payment||($ 4,000)|
|Car Loan Balance||$16,000 (@ 4% over 48 months)|
|Car payments||$ 361.26|
|Maintenance & Repair||$ 100.00|
|X 12 months|
|Total Annual Transportation Costs||$9,375.12|
|Total Required Family Income @ 10% Transportation Cost||
A major strength of this rule is that it provides good financial boundaries for those that wish to finance a more expensive vehicle, but don’t know where to start. It provides constraints on length of time, income and value of the vehicle to purchase all of which can be mismanaged if not handled properly. Most dealerships will offer a 7-8 year loan term on a vehicle. Although this reduces monthly payments, family taking 7-8 years to pay off their car loan will incur a lot more interest for a depreciating asset over this time.
Most families that want to own a newer vehicle and multiple newer vehicles may find it difficult to abide by this rule given the average family household incomes in America. For example, two $20,000 vehicles would require this family’s household income to almost double to meet the rule guidelines, which can be unrealistic for many families. However, going through a calculation like this one can help provide realistic expectations of what one can afford when financing a vehicle.
This simplified form of budgeting places our money in 3 major categories: essentials, savings and personal. This rule says 50% of your income should go towards taking care of your essential needs. These would include expenses that almost all of us would incur. For example: housing, transportation, groceries, utility bill etc.
Then, 20% of our income should go towards savings or building your net worth. This includes any financial transaction that would either lower our debt obligation (debt repayment) or increase our assets (savings and investing). This is your ‘getting ahead’ category and money used here should help improve your financial situation long term.
Lastly, 30% of your income should go towards personal expenses. These are expenses that are unique to you and what makes life enjoyable for you.
This rule is good because it provides a bit more flexibility on how you spend your money than other budget distributions, allocating 80% of your income to needs and wants. It also does not break down expense categories in minute details so people have more flexibility on how they spend. For example, many financial coaches’ advice people to spend no more than 25%-30% of their income on housing. However, this budgeting approach does not specify spending limits on each category and one is free to spend more or less than this amount so long as the sum of their percentages does not exceed the 50/20/30 rule.
This rule is not ideal for those living at home or having most of their essential expenses taken care of by someone else. For example, a new grad working full time and living with their parents would probably not need 50% of their income to go towards essential expenses. In these instances, the weight distribution of expenses will be skewed.
The 4% Rule
The 4% rule looks at retirement income withdrawal. Many retirees are worried about outliving their retirement income. This rule helps to provide some guidelines to ensure that there is enough money to cover a person’s full retirement.
This rule says that a person can withdraw 4% each year from their retirement nest egg (adjusted annually for inflation) to assist in funding their retirement. Withdrawing 4% while the money is still conservatively invested will ensure the retirement income does not run out before the person passes away.
This rule is helpful because if provides people with a framework on how to view their retirement income, making sure not to deplete it too quickly.
This rule should be avoided if the retiree is a high-risk investor (not advisable) and is not ideal for severe and prolonged market downturn. The 4% rule also assumes the individuals has their monies still invested but in more conservative options as they get older. This ensures that even though money is still being withdrawn, there is still some growth in the accounts.
Minimum 20% Towards Debt Repayment
This rule says to always allocate 20% of your income towards debt repayment. This ensures that you are managing your current debt obligation and hopefully not paying only the minimum payments on them.
It however, neglects to account for other financial priorities like saving for the future. This rule may also not be ideal for those focusing entirely on debt repayment as they want to put more than this amount towards their debt.
2-3 Times Gross Family Income for A Mortgage
Buying a home is the most expensive purchase that most households will make and figuring out how much ‘house’ you can afford can be a bit overwhelming as well. This rule cautions buyers not to purchase a home with a mortgage that is more than 3 times their gross family income. A very simplified version of the total debt service and gross debt service ratio (discussed next) this rule provides potential home hunters an idea of what they can afford.
This rule is simple to use and requires simple and quick math to come to a ball park figure. However, it’s simplicity also means less information is provided about the individuals living expenses including information on monthly mortgage expenses, utilities, condo fees (if applicable) etc. In addition to this, given the rising price of homes and home ownership for many metropolitan cities in the United States and Canada many cities income levels may not be able to pace with the rising home prices. For some, a mortgage of 3 times the gross family income is not feasible with current incomes making this rule inconsistent with the changing times.
Total Debt Service Ratio (TDSR) & Gross Debt Service Ratio (GDSR)
These commonly used credit thresholds are used by many financial institutions deciding whether to extent an individual credit (e.g. mortgage). Both ratios evaluate certain monthly expenses against gross family income.
The gross debt service ratio looks at whether the borrower can meet their basic housing costs with their current gross income (before taxes). Since housing costs (whether owning or renting) tend to be the biggest monthly household expense for most family households, these expenses must be taken care of before paying for other expenses and debts. For many lenders to consider extending credit, the gross debt service ratio should be 32% or less (some lenders may go as high as 39%). With 32% or less, this provides more confidence to lenders that extending additional credit will not cause undue financial hardship to the borrower.
Gross debt service ratio (GDSR) = [(Mort Pmts + Property Taxes + Heating costs + 50% condo fees)]
Gross Annual Income
The total debt service ratio looks at a borrower’s ability to meet their housing costs plus the minimum payments on their existing debts. Calculation of minimum payments may vary from one financial institution to another but they typically are a percentage of credit limit extended (e.g. 2%-3% of the credit limit extended). For many lenders to consider extending credit, the total debt service ratio should be 40% or less (some lenders may go as high as 44%)
Total debt service ratio (TDSR) = [(Housing expenses per GDS) + Minimum payments on other debts)]
Gross Annual Income
The Rule of 20 In Retirement
Figuring out home much money you need to retire comfortably can be very overwhelming, especially when you consider all the unknowns that come with planning for retirement (e.g. inflation, life expectancy, rate of return etc.). Regardless of the limitations to retirement planning, we still need to plan. The rule of 20 states that for every $1 of retirement income you want, you will need $20 saved in your retirement portfolio. For example, if you wish to withdraw $50,000 a year when retired, you would need to contribute $1 million towards your retirement nest egg. Keep in mind there is also government benefits that can contribute towards your retirement savings and these estimated amounts should be considered when doing this calculation.
This rule is simple to use and gives people a ball park amount of what they would need to save to have the retirement income they want in the future. However, due to the simplicity of the rule it has some limitations. Expenses probably play a bigger factor in being able to sustain retirement than income. If income is out of line with expenses, this rule is not as useful.
The Rule of 25 in Retirement
This rule is like the rule of 20, but focuses on expenses and not income. This rule states that you would need 25 times your annual expenses to retire comfortably. Those who like this rule appreciate its focus on expenses and not income as a truer measure of retirement readiness. However, being able to predict your annual retirement expenses can be tricky if you are not far from retirement.
If you follow a zero-based budget and strive to have no debt by the time you retire (or sooner hopefully), then your income would equal your expenses and this distinction will no longer be necessary.
The Rule of 72
I remember learning this rule in my finance class and not thinking much of it (mostly because I was a broke student like many) until I graduated and started to focus on getting out of debt and investing for the future. The rule of 72 estimates the number of years required to double your money at a given annual rate of return.
Years to double investment = [72 / (compound annual interest rate)]
For example, if your annual rate of return is 7% it would take you 10.28 years (72/8) to double whatever the value of your investments is at the time of calculation. Someone with a more conservative rate of return, let’s say 2% would require 36 years (72/2) to double their money. I found this rule helpful because sometimes it is difficult to conceptualize the financial impact of investments when expressed as rates of return. Especially if you are not a numbers person and accretion tables are not your thing. This rule was especially helpful when I first started learning about investing as it helped to translate the importance of a healthy rate of return and how not having this can impact the size of your investments and how quickly they grow.
There are tonnes of personal finance rules and newer ones coming out all the time. Of course, with every rule there are strengths and limitations, but overall, the above rules help to answer an important question to those who use them.