Financial Literacy

Financial rules of thumb offer broad, simple guidelines that help consumers save, spend, and invest their money. While these rules are a useful starting point for many, they may only apply to some financial situations.

How can you tell when to follow one of these financial "rules" and when to seek more information or take a different path? Let's examine a few common rules of thumb and evaluate their relevance. As we'll learn, thinking critically about financial advice is essential.

Rule 1: Your Home Should Cost 2 ½ Times Your Annual Income?

This rule of thumb and its relevance depends heavily on where you live and current interest rates. Both interest rates and taxes will impact the monthly cost of your home. For example, a $300,000 home in New Jersey could have annual taxes of about $12,000 – or $1,000 per month. Contrast this figure with a similar home in South Carolina; the same $300,000 home will cost about $1,500 yearly in taxes in most counties. While both houses have the same ticket price, the actual monthly cost and affordability are significantly impacted by taxation.

Additionally, this rule doesn't account for variations in down payment amounts or the length of the mortgage term. A larger down payment or longer mortgage term could make a more expensive home more affordable. Conversely, a smaller down payment or shorter mortgage term could make a home that's 2 ½ times your annual income less affordable (a mortgage with a shorter term will cost less overall, but the monthly payments will be higher).

Rule 2: A Huge Emergency Fund Is a Must?

Emergencies happen, and having some savings set aside can make it much easier for you to deal with unexpected expenses. Whether it is a damaged car engine, broken refrigerator, or overflowing sink, having money to deal with an issue without taking on unplanned debt eases stress and helps keep your finances on track.

Some financial experts recommend saving anywhere from 3-6 months of living expenses in an emergency fund. Really?

While everyone needs an emergency fund, the size of it can vary. Choose how much you'll need on hand based on your life circumstances and the emergencies you may encounter. An emergency fund of even $1,000 or $2,000 would cover many car repairs and is enough to replace many major appliances - an excellent place to start. Increase your savings as you can, with the goal of an emergency fund that could cover several months of expenses in the event of a loss of income.

However, this larger cushion can provide peace of mind in case of job loss or extended illness. The right amount for your emergency fund will depend on factors like job security, health, and whether you have dependents.

Rule 3: Save 10% of Your Income for Retirement?

While saving 10% of your income for retirement is a good starting point, most experts believe saving more if possible, especially if you have disposable income, have started saving for retirement later in life, have a disabled dependent, or have other circumstances that could impact the amount of money you'll need in retirement. If you can only scrape together 10%, that's a great starting point. However, aiming higher, like 15-20%, will go a long way toward building a more substantial nest egg and comfortable retirement.

It's also important to consider the impact of compound interest. The earlier you start saving, the more time your money has to grow. So, even if you can only save a small amount when you're young, it can make a big difference.

Rule 4: Never Cosign on a Loan?

Most experts suggest avoiding cosigning on a loan to protect your social and family connections, not to mention your financial health. Anyone close enough to you to ask you to cosign is someone you risk losing if things go wrong. Would you feel comfortable sitting across the Thanksgiving table from your in-laws after they defaulted on a loan you cosigned?

However, there may be situations where cosigning makes sense, like helping a child establish credit or assisting an elderly parent. In these cases, it's important to have open, honest conversations about expectations and responsibilities. You should only cosign if you're willing and able to take on the debt yourself if the primary borrower can't pay.

The Takeaway

Learning more about financial rules of thumb – and when to take them with a grain of salt – can help you make the most of your income and savings. For best results, consider these "rules" as guidelines. Make sure they truly suit your financial situation before making significant changes. If you have questions about your financial plan, consider consulting with a financial professional to develop a personalized roadmap for your unique situation.

Compound interest is a fundamental concept in saving and investing that can significantly increase wealth over time. It allows you to earn interest on both your original investment and the accumulating interest. To easily figure out how quickly your investment might double, you can use the Rule of 72. This straightforward method simplifies the power of compounding.

What is Compound Interest?

Compound interest is the interest on a loan or deposit calculated based on the initial principal and the accumulated interest from previous periods. Unlike simple interest, which only earns interest on the principal amount, compound interest earns interest on both. So, assuming the interest is compounded periodically, your investment grows at an increasing rate.

Consider this question: Would you rather have one million dollars or a penny that doubles in value each day for four weeks?

• Day 1: You start with $0.01
• Day 2: The penny doubles to $0.02
• Day 3: It doubles again to $0.04
• Day 4: Now, it's $0.08

The process continues each day, doubling the previous day's total. This might not look impressive initially, but as days pass, the power of compounding really kicks in. So by Day 28, the amount you would have isn't just a few dollars - it's $1,342,000. And half of it was earned on the last day.

Since investments with a 100% daily interest rate don't exist, here's another example: suppose you invest $10,000 at an annual interest rate of 5% and never add more. After 40 years, with simple interest calculated on $10,000 alone, you'd have $25,000. But with compound interest, you'd have nearly $75,000 - quite a difference! 

Deciphering the Rule of 72

The Rule of 72 is a straightforward formula used to estimate the years it will take for an investment to double in value, given a fixed annual interest rate. By dividing 72 by the annual interest rate, you can get a rough estimate of how long your initial investment will take to grow twofold.

For example, if an investment yields an annual interest rate of 6%, dividing 72 by 6 gives you 12. This fact means your investment would take approximately twelve years to double. If the interest rate were 8%, it would take nine years. If the interest rate were 10%, it would take just over seven years.

While the Rule of 72 is helpful, it's important to recognize its limitations. The rule provides an estimate, not an exact number, and works best for interest rates between 6% and 10%. For rates outside this range, the rule's accuracy diminishes. Moreover, it assumes a constant rate of return, which might only be realistic for some investments.

Applying the Rule of 72

Understanding and applying the Rule of 72 can have profound implications for your financial strategy. By comparing different investment opportunities and their associated interest rates, you can use the it to gauge how long it might take for your investments to double. 

The Rule of 72 can help you estimate how your retirement savings might grow. Knowing how long it takes for your investments to double can inform how much you need to save to reach your retirement goals. For example, suppose you're 30 years away from retirement, and your investments are expected to double every 12 years. In that case, you can anticipate them doubling at least twice, possibly thrice, before you retire.

And the Rule of 72 isn't just for growing your investments - it can also apply to debt. If you have high-interest loans, the rule can show how quickly your debt might "double" if you only make minimum payments. This perspective may motivate you to prioritize debt repayment, especially for high-interest debt, to avoid paying significantly more over time.

The Takeaway

The Rule of 72, combined with an understanding of compound interest, forms a powerful duo that can significantly impact your thinking about both investing and debt management. Whether evaluating investment opportunities, planning for retirement, or strategizing to eliminate debt, these principles offer clear guidance - no calculator required. 

Managing your finances doesn't have to be complicated. The 50/30/20 budgeting rule is a straightforward method that simplifies financial planning by breaking down your income into three manageable categories. This rule is designed to help individuals find a balance between meeting essential needs, enjoying what money can buy, and saving for the future.

The rule divides your after-tax income into three categories: 50% for needs, 30% for wants, and 20% for savings or debt repayment. From there, you can create a balanced financial plan that covers your essentials, allows for enjoyment, and grows your savings. Let's explore how this rule works and how you can apply it to your finances.

How it Works

The 50/30/20 rule is about balance. Here's a breakdown of each category:

• 50% Needs - This portion of your income should cover what you need to live and work. It includes rent or mortgage, utilities, groceries, insurance, and minimum debt payments. Sticking to 50% ensures you're not overspending on necessities, leaving room for other financial goals.

• 30% Wants - This is for the things you enjoy but don't necessarily need. Dining out, hobbies, subscriptions, and vacations fall into this category. It's important to allow yourself some pleasures to maintain a happy, sustainable lifestyle without compromising your financial health.

• 20% Savings or Debt Repayment - The final slice of your income should go towards building your future. This category includes savings, investments, and extra payments on any debts you have. Prioritizing this category helps secure your financial well-being and prepares you for unforeseen expenses or retirement.

While some adjustments may be needed based on your specific financial situation, the broad guidelines of the 50/30/20 rule can serve as a cornerstone for almost anyone's monthly budget.

How to Get Started

Here's how you can apply this rule to your finances:

Step 1: Calculate Your After-Tax Income 

Begin by determining your net income, which is the amount you take home after taxes, Social Security, health insurance premiums, and any other deductions from your paycheck. If you have irregular income, average your income over the past few months to get a monthly average.

Step 2: Define Your Needs (50%) 

List out all of your essential expenses, including housing (rent or mortgage), utilities, groceries, transportation costs, insurance premiums, and minimum payments on debts. The big idea is that these expenses should be at most 50% of your net income. If they do, you may need to reevaluate what you've classified as a "need" or find ways to reduce these expenses.

Step 3: Allocate for Wants (30%) 

Wants are more flexible and include expenses like dining out, entertainment, hobbies, and non-essential shopping. The rule suggests allocating 30% of your net income to these expenses so you can enjoy life without overspending. If you need help staying within this limit, prioritize what you want to fit within your budget.

Step 4: Prioritize Savings and Debt Repayment (20%) 

This category is essential for building financial security and includes savings for emergencies, retirement, and paying down high-interest debt. If you allocate less than 20% of your income to this category, consider ways to adjust your needs or wants budget to increase your savings rate.

Applying the 50/30/20 rule isn't a one-time task but an ongoing process of monitoring and adjusting your finances. It's okay if your percentages could be better aligned from the start. The goal is to work towards a more balanced financial life where you can meet your current needs, enjoy life, and save for the future. To help automate the process, consider using this website's monthly budget and budget tracking tools. With a personalized account, you can track your progress from month to month and even export your figures for use anywhere.

Is the 50/30/20 Rule for You?

While the 50/30/20 rule is a general guideline, your circumstances might require adjustments. For example, if you're in a high-cost living area, your needs might take up more than 50% of your income. On the other hand, if you're aggressively paying down debt or saving for a big goal, you might choose to allocate more to savings and less to wants. The key is maintaining a balance supporting your current life while ensuring a secure financial future.

The beauty of the 50/30/20 rule lies in its simplicity and flexibility. It's straightforward enough for budgeting beginners to understand and implement, yet adaptable for those with more complex financial situations. By following this rule, you can ensure that your essentials are covered, your future is secured, and you still have room to enjoy life.

The Takeaway

Success with this rule comes from understanding your financial habits, making informed decisions, and adapting to life's changes. The goal isn't to restrict your life but to enhance it by creating a budgeting plan that brings balance, reduces stress, and sets you up for long-term financial security.

Retirement planning is a critical aspect of financial health, requiring strategic thinking about how much to save, where to invest, and how much to withdraw. Adhering to time-tested financial rules of thumb can provide a starting point for crafting a retirement plan that aligns with your goals, lifestyle aspirations, and financial status. While no rule of thumb is a solution for every situation, here are some rules of thumb to consider in the context of retirement planning.

The 20 Times Income Rule

A widely accepted rule of thumb is to aim for a retirement nest egg at least 20 times your annual salary. This benchmark provides a general target, suggesting that saving and investing a portion of your income over your working years can offer a sustainable withdrawal rate during retirement and minimize the risk of depleting your savings too early.

However, this rule doesn't account for variables like long-term care needs or lifestyle changes, which could significantly affect your financial requirements in retirement. Adapting your savings strategy to include potential future healthcare costs or lifestyle aspirations is crucial for a comprehensive retirement plan.

Diversification Rules of Thumb

"Diversification" is more than just investment jargon; it's essential advice that means spreading your investments across various asset classes to reduce risk. The rule of not putting all your eggs in one basket holds true, especially when planning for retirement. When you concentrate all your capital on a single investment, you're gambling on a single outcome. Should that investment underperform, your entire retirement fund will also underperform.

A mix of stocks, bonds, and other investments can help protect your retirement savings from market volatility and ensure consistent growth. Employer-sponsored plans like a 401(k) offer a straightforward way to diversify through mutual funds, with potential employer matching a significant plus. Taking full advantage of these plans can significantly impact your retirement savings, thanks to compound interest and tax advantages.

Age-Based Rules

One of the critical aspects of diversification is managing risks - and how your age may influence your risk tolerance. As investors age, many experts suggest a gradual shift from higher-risk investments like stocks to more stable options such as bonds. The age-based formulas come into play in this situation, providing a simple yet effective guideline for adjusting your investment strategy over time.

The first of these rules of thumb involves subtracting your current age from 100 to determine the percentage of your investment portfolio that should be allocated to stocks. For example, if you're 40 years old, according to this formula, 60% of your portfolio should be invested in stocks, with the remaining portion in bonds and other less volatile investments. This traditional approach is designed to gradually reduce your exposure to risk as you get closer to retirement, aligning with the principle that younger investors have a longer time horizon to recover from market volatility, whereas older investors might not.

However, recognizing that life expectancies are increasing and many individuals are working and staying active well beyond traditional retirement ages, a modified version of this rule suggests subtracting your age from 120. This adjustment allows for a slightly more aggressive investment stance, reflecting the need for your portfolio to grow over a more extended period. For example, a 40-year-old would allocate 80% of their portfolio to stocks using this revised formula. This approach acknowledges that with longer life expectancies, the fear of outliving one's savings becomes more pronounced, necessitating a strategy that emphasizes growth for a prolonged period.

Both rules of thumb are starting points for tailoring your investment approach to match your risk tolerance. It's important to note that these guidelines are not one-size-fits-all solutions. Individual financial goals, income levels, and personal circumstances are crucial in determining the most appropriate allocation strategy. For some, a more conservative approach may be warranted due to specific financial obligations or risk aversion. In contrast, others may opt for a more aggressive strategy to achieve their financial goals.

The 4% Withdrawal Rule

The 4% withdrawal rule is a widely recognized guideline used by retirees to manage their retirement savings. It suggests that you can withdraw 4% of your retirement portfolio's total value in the first year of retirement and then adjust that amount for inflation in subsequent years to sustain a steady income stream for at least 30 years without depleting your nest egg. 

To apply the 4% rule, you first calculate 4% of your retirement portfolio's total value at the time of retirement. For example, if you have a $1 million portfolio, you would withdraw $40,000 in the first year. In the second year, you adjust the $40,000 by the previous year's inflation rate to maintain your purchasing power. This process repeats annually, theoretically allowing your savings to last through a 30-year retirement.

While the 4% withdrawal rule offers simplicity and accessibility, it's essential to be aware of its limitations. It relies on historical market returns, which may not accurately predict future conditions. It also may not fully account for individual circumstances such as varying lifespans, unexpected healthcare costs, or significant changes in personal expenses. Additionally, periods of high inflation or poor market performance early in retirement can erode the purchasing power of withdrawals.

While the 4% rule is a valuable guideline, it's important to remember that it's not a rigid rule. Financial planners often recommend using it as a starting point, but it's crucial to remain flexible. 

The Takeaway

While the rules of thumb for retirement savings offer valuable guidance, tailoring your plan to your unique circumstances is vital. Regularly revisiting your investment strategy to adjust for life changes and evolving retirement goals will help ensure your retirement planning is robust and responsive to your needs.

No single strategy fits everyone, highlighting the importance of informed, flexible planning and, when necessary, consulting with a financial advisor to adapt these general guidelines to your specific situation. 

Student loans are often necessary when paying for college. A general rule of thumb suggests that your student loan debt at graduation should be at most 90% to 100% of your expected starting salary. This guideline is a benchmark for borrowers to maintain a manageable debt-to-income ratio after graduation, ensuring that education loans are less likely to jeopardize future financial stability.

According to the rule, for example, suppose you expect to earn a starting salary of $50,000 in your first job after graduation. In that case, your total student loan debt should not exceed $45,000 to $50,000.

Why it Matters

The reasoning behind this rule is simple: keeping your student loan debt aligned with or below your starting salary makes it more likely that you can meet your repayment obligations without undue stress. A standard budgeting guideline is that your total monthly debt payments (including student loans, car loans, credit card debt, etc.) shouldn't exceed 36% of your gross monthly income. So, by keeping your total student debt close to your starting salary, you're more likely to manage your payments within this 36% threshold.

Taking on too much student debt relative to your income can have ripple effects throughout your financial life. High monthly loan payments can make saving for goals like retirement or a down payment on a house more difficult. It can also force you to delay milestones like getting married or starting a family.

Excessive student debt can also limit your career choices. Someone with very high debt may feel pressured to take a high-paying job you're not passionate about to keep up with loan payments rather than pursue a lower-paying but more fulfilling career path.

Applying the Rule

To apply the 90/100 Rule, you'll need to research and plan ahead. For a quick estimate of starting salaries in hundreds of career fields, try our Maximum Student Loan Calculator. 

Next, calculate the total cost of your education. When comparing college costs, it's critical to consider "net cost" versus published tuition. Few students pay full tuition at many schools, especially at private colleges and universities. Try our College Explorer to estimate the net cost of attending any school in the United States. After subtracting college savings, scholarships, and grants, you'll get a rough idea of how much borrowing may be required for each school. 

If your total borrowing needs exceed 90-100% of your expected starting salary, look for ways to reduce costs. This could include choosing a less expensive school, living at home to save on housing costs, or working part-time to offset some of your expenses.

Exceptions to the Rule

While the 90/100 Rule is a helpful guideline, it may make sense to borrow more in some situations. For example, suppose you're pursuing a career with a clear path to rapid salary growth, like specific fields in medicine or law. In that case, you may be able to manage a higher debt load. 

In addition, some professions, like teaching and careers in the government and nonprofit sectors, offer loan forgiveness programs that can make a higher debt load more manageable - especially for those with graduate degrees and a relatively high level of debt. If you plan to take advantage of these programs, factor that into your borrowing decisions. But remember that forgiveness programs offered through the federal government, like public service loan forgiveness, only apply to federal student loans - not loans borrowed from banks, credit unions, or other lenders. 

Finally, for some, pursuing a specific career or vocation is a calling that transcends financial considerations. Careers in social work, education, or the arts may not always promise high salaries. Still, the personal and societal value they provide can be immeasurable. Individuals driven by passion and a desire to make a difference may view the benefits of their chosen path as outweighing the financial implications, warranting an exception to the rule.

The Takeaway

The 90/100 Rule for student loan debt is a guideline, not a hard and fast rule. The right amount to borrow will depend on your circumstances, career path, other financial obligations, and risk tolerance.

However, the underlying principle of the 90/100 Rule is sound - borrow with your future in mind. By planning wisely and considering future earnings when taking on debt, graduates can set themselves up for a successful and financially stable start to their working lives.