There are plenty articles about the best financial rule of thumb scattered all over the internet, but most are now outdated or just rubbish. If you want to build wealth, you need to save more, and be aggressive managing your money. To do this, a different approach is needed, I have modified the most popular financial rules of thumb for you to follow instead.
I am not a professional financial planner so my advice is my opinion. I follow the common sense approach to finance; all debt is bad, more savings is always a good idea, and minimalist living is the key to a happier life. Sounds a lot like Dave Ramsey financial guidance and it should, because a lot of what he tells people is good advice.
Some of the financial rules of thumb below are a really good start and I just modify them a little to be more conservative towards savings. For example, I would never borrow money if it can be avoided, so buying a new car using borrowed money makes no sense to me.
14 “Modified” Financial Rules of Thumb I Follow
The 50/30/20 Rule
This is a popular rule for breaking down your budget. The 50-30-20 rule is 50% of your income for necessities, like housing and bills; 30% for wants, like dining or entertainment; and 20% for financial goals, like paying off debt or saving for retirement.
The purpose of the rule is to help better balance your life without overspending on some areas (like wants). The rule was first published in 2005 in a book “Your Worth: The Ultimate Lifetime Money Plan” by Elizabeth Warren. The formula is based on the simple fact if you save 20% of your income for 40 years (typical career lifespan), you will have about 20x your income and will be able to sustain part your income into your retirement years.
But, I question the stability of being able to work for 40 years, the amount of money you will need in retirement, and the ability to apply all your 20% to retirement savings as apposed to other savings goals, like buying a house.
I personally follow something different. My budgeting percentages are around 50% necessities, 20% wants, and 30% financial goals. I am willing to sacrifice a little today for a brighter future tomorrow.
Another issue I have with this rule is the 20% for savings and paying off debt. If you have debt, you need to apply the maximum you can afford to get that paid off as quickly as possible. If this means you cut necessaries, then that’s what you do.
The 20/4/10 Rule for Buying a Car
The 20/4/10 financial rule of thumb cab buying says you should put down at least 20%, keep your car loan limited to no more than four years (to avoid interest) and spend no more than 10% of your gross income on transportation costs.
Why is this rule in existence? Because the average used car prices topped $20,000 in late 2018, according to Edmunds, while the average new car transaction price was higher than $37,000 in January 2019, according to Kelley Blue Book.
With prices that high, some sort of method is needed to buy into one of these options. I am pretty sure this ‘rule’ was created by the auto and banking industry because it will not benefit the buyer in anyway!
Leasing a new car is one of the worse financial mistake you can possibly make, second only to buying a new car (IMHO). Buying a used car has a much lower TCO and is often a much better financial option for most people. Let me help you avoid this mistake by modifying this rule to be used for a quality used car instead.
Please remember that buying a new car is not an investment, but rather a massive expense for a rapidly depreciating asset. You will lose as much as a third of a new car’s value in the first year of ownership.
I personally hate debt and would save up for as long as needed to only pay cash for a car. But if you must take a loan for a car, then I would follow this approach.
I would put down at least 50% for the car, with a 2 year loan, and make sure the car costs under 10K.
The price of the car will depend on your income. I believe you should not spend more then 3-4% of your yearly income for transportation costs (car loan, fuel, insurance, maintenance). I understand most people recommend 10% but I think that is too high.
According to the most recent U.S. Bureau of Labor Statistics for 2016, the annual average expenditure on vehicle purchases was 4.9% of gross income, roughly half of the 10% figure above.
Shop around, buy a beater, or use public transportation until you are able to afford driving the car you want.
Buy a New Car and Drive it for at Least 10 Years
This financial rule of thumb tells people to buy a new car and drive it for 10 years, but it is not considering the 1/3 car depreciation you will experience during your first year. This is not sound financial advice.
A better approach is to buy a quality used car and drive that for at least 10 years. Most people will argue that if you buy a 3-4 years old car and drive it for 10 years, the maintenance costs for a 14 year old car will be higher then the costs of a new car.
This is rubbish!
My family has about 7 cars and the newest one is a 2011. My oldest cars are a 1989 Jeep wrangler, two 2006, and three 2008 vehicles. I spend about 5K a year for all of them or about $700 per car. Also, older cars are a lot cheaper to insure.
Avoiding the new car dream is a great way to kick start your financial journey to a more stable and bright future.
20% Income to Transportation Costs
This financial rule of thumb tells us not to spend more than 20% of your take-home pay on all costs for all the vehicles you own. Meaning its OK to spend 20% of your income on a car, but not 21%. This includes costs like insurance, fuel, and maintenance.
Some people will see this as limiting if you’re shopping for an expensive vehicle. To those people I say WAKE UP!
I already talked about the average family spends under 5% of their total income on transportation costs so why would someone want to spend this much on a car?
My rule would be to spend less then 5% Income to Transportation Costs.
I sort of get it, some cars are really nice and if you are rich enough (like a multi-millionaire) you can probably afford some of these 100K sports cars. But for most of us, wasting this much money is just paying a stupid tax!
Be smart and limit your car and transportation costs to around 3% of your income and spend more of your hard earned money elsewhere.
The 20% Rule for Home Buying
This financial rule of thumb simply says you should put at least 20% down when buying a home. The issue I have with this rule is people’s perception and they miss the whole point. The always focus on the 20% part, and totally ignore the “at least” part.
I would change this to read “at least 35% Rule for Home Buying“.
I know homes are expensive but people always over buy into more square footage then they actually need or should have. Live like a European I always say and embrace their lifestyle of walking, eating fresh food, and live a minimalist lifestyle, starting with the size of your home.
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. The point is to set a reasonable guide for the home price according to your income level. If you make 100K a year, then you can afford a home in the 200-300K area.
Of course there are areas of the country and world that home prices are crazy high and 300K will barely get you into a 500 square foot studio. This rule should apply everywhere, because the rule basically tells you what you should be able to afford, and your zip code will not change your mortgage payment.
I would change this financial rule of thumb to be a little more generous.Â
I would tell people “Don’t get a mortgage that costs more than two years’ worth of your gross annual income.“
This would reword people for coming in with a higher down payment, doesn’t affect the monthly payment, and give the owner more equity in the end.
Don’t Prepay a Low-Rate, Deductible Mortgage
Deciding whether or not to prepay on your mortgage can be tough. But, generally, the rule is telling people if you’re already getting a good rate, you should use that money for other important financial goals.
This is another rubbish rule because all debt is bad and it doesn’t matter if the interest rate is low or if you can write off the mortgage interest on your taxes.
My modified financial rule of thumb would be: “Put all available money to debt, including your mortgage.”
I am a firm believer of a 15 year mortgage with 1/3 to 1/2 down and doing double payments so the actual home will be paid in under 7 years. If you apply this calculation to the home price, then you will be shopping for a home you can truly afford and not something that is over prices and actually owns you.
Save 10% of Your Income for Retirement
This has been around for many years and I loved the way it was portrayed in the George Clason book “The Richest Man in Babylon“. His famous line “10% of what you make is yours to keep” helped drill this into many peoples minds and financial plans.
If you go to any retirement calculator and put in a 10% per year savings, you will run out of money during retirement in about 12 years. The 10% rule is just not enough. Actually, 20% isn’t even enough as you will run out of money in about 25 years. Not sure about you, but I want to live as long as possible and I want to make sure my money will outlast me.
If you are more aggressive and smarter with investing your money, you can probably expect better returns and stretch the numbers above. The goal is to get 8% returns while you are working and 6% in retirement, you can make the 10% savings rate last to about 78. If you increase your savings rate to 20% (which is what I recommend to friends and family), your money will now make it to past 125.
So my modified financial rule of thumb should say “Save 20% of your income for retirement and invest it smartly“.
You Should have 20x Your Gross Annual Income for Retirement
This number just doesn’t work at all. Lets do the math and we need to apply the 4% rule if you are going to live on 100% of the income you had while working (to maintain your existing lifestyle).
The 4% rule simply says you are allowed to withdraw 4% of your nest egg in retirement. If you allow for 3% inflation and a 4% withdraw, your money need to earn at least 7% while in retirement. If you can earn 7-8% in retirement, then your money should never run out.
The issue is the 20X rule is not enough to be able to withdraw 100% of your annual income in retirement. In order to do this, you will need at least 25x.
So this financial rule of thumb should say “You should save 25x your gross annual income.“
So our plan is simply to grow the nest egg so that a 4% withdraw will equal 100% of your desired income in retirement. This number is 25. If you want to withdraw 100K a year in retirement, you will need 2.5M in your nest egg. Then you can withdraw 4% (100K) for life and probably never touch the principle.
The 20X rule was designed to withdraw just 80% of your annual income in retirement, but this may require a lifestyle change and most people would rather keep their working lifestyle in retirement and therefor need to have 5x more money saved to achieve their goals.
You’ll need 70% to 80% of Your Preretirement Income in Retirement
This financial rule of thumb simply says you will need less money in retirement because it is assuming a lot of your working years expenses are under control. I don’t assume that and I know too many people in their retirement years still paying off a mortgage or have new medical expenses to pay every month.
Most investment professionals have done a lot of research on how much money you will need in retirement and their calculations produced the 70-80% number in this rule. Their calculations often vary on how you will spend your time, how long you will live, ,and what inflation will look like in your retirement years. These variables plus several more make it near impossible to accurately predict how much money YOU will need, because everyone is different.
If you want to maintain the lifestyle you had while you were working, I believe you will need 100% of the income you had in your working days to also be your income in your retirement years. This in combination with the 4% rule above will tame some of the unknowns above. There is no way anyone can predict what the future will be like, so I prefer to error on the side of caution and have more in the bank just in case.
The 6-Month Emergency Fund Rule
The financial rule of thumb tells people you should have six months’ worth of living expenses on hand in case of an emergency. This has been the gold standard for many years, but times have changed.
An emergency can be anything like needing to replace a car, medical issues, or the loss of a job. All these things are very expensive and just 6 months will likely not cover these costs. In 2020, the job market and unemployment crashed for over 12 months leaving people scrambling wondering how to pay their bills.
If you make 100K a year, the 6 month rule will put 50K away in cash just in case an emergency comes up.
I think this needs to be 9-12 months emergency fund, and personally I keep several years set aside.
Why do I recommend so much? Because most of the time, you will not just be dealing with a single problem. If you were to get hurt and cannot work, you will have high medical bills and no income. I had a friend who ran his own business. He fell off a ladder and got hurt. He had 50K in medical bills, lost 9 months of income while he was recovering, and had to sell his business and equipment to eat and pay rent. If he had an emergency fund of 9-12 months, he would still have his business and his medical bills paid. Instead it took over 10 years to recover and get back to where he was in 2010.
Fortune favors the prepared.
Own Your Age in Bonds (OYAIB)
When investing, bonds are generally less risky than stocks. So the rule follows that the older you get, the less you should invest in stocks. This financial rule of thumb says that the percentage of bonds in your portfolio should equal your age. If you are 40, then 40% of your money should be in bonds. If you are 80, then 80% of your assets should be bonds. Simple!
Why this doesn’t work anymore? Longer lifespans and lower bond returns make the 4% rule almost impossible to live on. Bonds would need to earn a few points over inflation in order to be considered today and that is just not the case.
I prefer the Warren Buffet approach. His recommendation is to use the 90/10 rule and just 10% of your portfolio should be in bonds. The rest in low cost, low turnover index funds. The growth in the 90/10 approach will buffer your nest egg and allow you to weather the down turns even in your retirement years. But this approach needs a healthy nest egg or a very strong will.
Limit Student Loans to Your First Year’s Expected Annual Salary
This financial rule of thumb saying to limit your student loan borrowing to your first year’s expected annual salary has many flaws. The biggest one is who knows what you will be making after college?
While I do completely agree that you need to take into account your expected salary with selecting any major, determining future loans on the expectation of a certain salary is just crazy. It is a bad idea to borrow money without a solid plan on how to repay it back.
An education is an investment in yourself, and the ROI is a critical factor in deciding if the costs of that education are worth the time and money spent on it.
A better rule I like to follow is to limit your student loan borrowing to what you can pay back within your first year after graduation. For most people, this should be around 15-25K max.
By following this modified rule, you can still get an education but you will need to earn more money while in school, go to a less expensive school, and maybe do a few semesters part time while you. There are plenty of ways to reduce your college expenses and it will just take some side hustling and creative thinking to get you there, which may be the best lesson you actually learn in college!
An Engagement Ring Should Cost Three Months Gross Salary
This rule stipulates that if a man makes $80,000 a year, he should spend $20,000 on an engagement ring! What kind of nut came up with that idea? I know, the jewelers who are selling you the rings.
The national average engagement ring costs about $5500 and the average salary of a gentleman between 25-35 is just under 50K. This means a the national average for an engagement ring should be over 12K, so we know that most people just ignore this rule already.
Taking advice from the Financial Samurai, he rule is to use his Car Rule from his post “The New Rule For Engagement Ring Buying“. In this article, he states that a “man should spend up to, but no more than the initial purchase price of his car.” His reason is very simple and true. He states that “cars are to men what engagement rings and are to women.” If you are willing to drop 10, 20, 40K on a car, then you should do the same for an engagement ring for your soon to be wife.
But this can get out of hand very quickly as car prices continue to rise every year. Also, people get married when money is still very tight and most people are still paying off student debt. I also think a reliable car is required to get you to and from work and often can be considered more of a need. IF you made a mistake and overpaid for a new car, you need to fix that by selling your car instead of compounding your financial problems by also buying a crazy expensive ring too.
So what should you do instead?
“A man should spend up to 10% of his annual salary on an engagement ring.”
This is similar to the Financial Samurai’s rule because he also tells people to spend a max of 10% of your salary on a car. If you follow this rule, you will also be spending 10% on an engagement ring too.
Conclusion
A Rule of Thumb is supposed to be simple, easy to follow, and produce the results you need. This list of the “14 popular financial rules of thumb you should forget” are easy and simple, but will not improve your financial situation.
I am a natural saver and therefor more aggressive in my advice above. My goals are simple. I think we should spend less, save more, and plan for the future. I also believe in enjoying today but don’t think enjoying life needs to cost a lot of money.
Please note that I am not a financial professional and this is a list of how I apply these rules of thumb in my personal life. Everyone had different life goals and this advice may not apply to your situation. Please read my site disclaimer to understand more about my background and site guidelines.
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Thanks for reading.