10 Best Financial Rules
Rules of thumb are a good starting point for getting your finances back on track, so we’ve put together ten good tips to follow. However, since everyone’s situation is different, we have also included scenarios in which these rules are most applicable.
Budgeting
The 50/30/20 rule
This is a popular budget breakdown rule. The 50-30-20 rule is 50% of your income for basic necessities such as housing and bills; 30% for needs, such as meals or entertainment; and 20% for financial purposes such as paying off debt or saving for retirement.
There are looser variations of this rule, such as the 80-20 rule, in which you use 20% of your income for financial purposes and spend 80% on everything else.
Why it works: If you’re unsure of where to start your budget, breaking it down into these main categories can be really helpful. These percentages help create a balance between commitments, goals and costs.
When He Doesn’t: If you don’t make a lot, you couldn’t afford the luxury of only spending half of your income on basic necessities.
You can always create a budget that is more tailored to your situation – start from scratch and follow these budgeting steps to come up with a plan that works best for you.
Buying a car
Rule 20/4/10
When buying a car, you must mortgage at least 20%, limit your car loan to no more than four years (to avoid interest), and spend no more than 10% of your gross income on transportation costs.
Why it works: It keeps you from buying more cars than you can afford. Cars are expensive to maintain, and this formula takes your current car budget into account when calculating your total travel costs. These expenses include paying for the car, parking, gasoline and insurance (which depends on the type of vehicle).
When not: Depending on your situation, these numbers may not be realistic to you. For example, you might spend more than 10% of your gross income on transportation because you have a long and grueling road ahead of you in a low-paying job. Since you need your car to work, you can look elsewhere in your budget to cut costs.
Rule 10 years
This rule has to do with the decision whether to buy a new or used car. If you want to add value to your car, you should either buy a used one or a new one and drive for ten years.
Why it works. According to Carfax, this rule minimizes depreciation losses – a new car loses 20 percent of its value in its first year of ownership. Buying a used car, however, sucks, minimizes the depreciation that has already been sucked out of the vehicle. If you buy a new car and keep it for ten years, you are optimizing its value and depreciation will not matter as much.
When it doesn’t : A used car is more likely to break down and require repairs. Make sure the service is not more expensive than the cost of using a used car.
Generally speaking, research is important when considering all variables. Edmund has an availability calculator and we’ve written about four questions you should ask when choosing a new or used vehicle.
Home ownership
Rule 20%
When buying a home, you must invest at least 20% .
Why it works: It ensures you don’t buy more home than you can afford, lowers your monthly mortgage cost, and can increase your chances of getting a loan. You also don’t have to pay for private mortgage insurance .
When not: While this is usually taken as practical advice, opinions vary. Some consider 20% unrealistic as it is a huge amount to save.
Income rule
Don’t buy a home that is worth more than your three-year gross annual income. Some options say no more than two years; others say two and a half.
Why it works: It sets a rough limit on how much home you can (or should) afford.
When it doesn’t: This rule doesn’t account for how much money you have in reserve, so it might make more sense to look at your net worth rather than your income. Another factor is living in a big city, where houses are more expensive but still offer long-term value as an investment.
These general rules give you an approximate amount at which you can start thinking about home ownership. But there is a long list of costs, including closing costs , that should be considered as well. And all this in different ways. Check out our list of home ownership costs you might be missing out on before you start looking.
Retirement
10% rule
“Save 10% of your income for retirement” is a very common rule of thumb.
Why it works : Gives people a simple number to work with. If you’re young, just opened a 401 (k) and don’t know how much of your earnings to put aside, 10% is a good start.
When it isn’t : While 10% is a simple rule to follow, this percentage doesn’t take into account how much you really need in retirement . It also doesn’t count how much you’ve currently saved. If you play catch-up, you probably have to save more than 10% of your income. Likewise, if you want to retire earlier or more generously, you will probably need to save more than 10%.
Income rule
You should be saving 20 times your gross annual income.
Why it works: Helps you focus on what you need in the future.
When it doesn’t: This is more of a standard test than a universal formula. Your retirement expenses may differ from what income you are currently earning, and depending on the lifestyle you plan to lead, you may need a lot more (or less) than 20 times your income.
These retirement rules offer rough numbers, but if you want a more precise approach that takes into account all the variables, develop a detailed vision for your retirement. Then calculate how much this lifestyle will cost.
Student loans
First year wage rule
You should not take on more student loans than you expect in your first year of employment.
Why it works : This ensures that you are charging an affordable amount that you can pay back.
When this does not happen: the soaring rates of fees made the observance of the rules of a challenge, as well as the unemployment rate immediately after graduation.
This is a sticky and complex topic. Since we are in the midst of a student debt crisis, let alone a recession, this rule is easy to dismiss. But it’s important to have a realistic idea of what your post-graduate income and benefits will look like, especially where your specialty is concerned. You will also want to compare tuition fees across universities to better understand what you can afford.
Savings and investment
6 month contingency fund rule
You should have six months of emergency savings on hand.
Why it works: Obviously, it is a great help in case of an emergency in your life. It saves you the trouble of making desperate decisions that can throw you back.
Why it doesn’t: There are many different opinions about how much you should save, but as we know from the pandemic, even that may not be enough.
When you’re broke, it can be very difficult to hear “you should save your contingency fund,” so with that in mind, here is a Lifehacker post on alternative ways to get emergency cash.
Age rule for stocks
When investing, bonds are usually less risky than stocks. Thus, the rule follows: the older you get, the less you should invest in stocks. To put a number, subtract your age from 120 (the old rule was 100 , but now many experts say 120 makes more sense); it is the percentage of your portfolio to invest in stocks.
Why it works: It gives you a general idea of what your asset allocation should look like based on your age.
Why not: This rule does not take into account the incredibly low interest rates that we have had to contend with in recent years. It also assumes your retirement based on your age. If you plan to retire early, you will need to adjust.
If you want a better idea of how much you should have saved on stocks and bonds, consider using an online tool like Portfolio Visualizer or Personal Capital to help you visualize your retirement planning.
Most of these rules are fairly reliable, time-tested methods for planning your finances. But again, personal finance is everyone’s personal business . Consider these rules a good starting point – to truly stay on top of your finances, research and individual planning is a must.
This story was originally published in December 2014 and updated on October 30, 2020 to update links and include new information.