We all make financial decisions in our everyday life from determining whether a certain expense is a need or a want to prioritizing which expenses need to go first among those necessities.
Everyone’s situation is different that is why no single financial advice can be considered best for all. However, there are some “rules of thumb” which may serve as our guideline when it comes to making financial decisions.
The Savings Rule
Pay yourself first. If you’re an employee, you should set aside at least 20% of your gross pay to savings first before you consider spending it. Use the equation Income less Savings equals Expenses. Save first before you spend. After savings, you may use the remaining 80% for necessities like housing, food, transportation, and entertainment.
The Emergency Fund Rule
Emergency fund is used in times of uncertainties like if you’ve lost your job, you got hospitalized or someone had an accident. In building your emergency fund, it is a must to know whether you are the breadwinner of the family or not. Ideally, you should save at least 6 months of your monthly expenses. Take note, it should be your monthly expenses and not your monthly income. However, if you are the breadwinner of the family, you should save at least 1 year of your monthly expenses.
The Age Rule for Stocks Allocation
When it comes to paper asset investments, the most famous are bonds and stocks. The Age Rule for Stocks states that in allocating your portfolio, you should subtract your age from 100 and the difference should be the percentage of your portfolio that you can invest in stocks. This is because stocks are considered as aggressive type of investment which carries more risks and the higher potential for a loss. Therefore, the older you get, the less aggressive your investments should be. So if you’re currently 30 years old, you should only invest a maximum of 70% of your portfolio to stocks.
The 20/4/10 Rule in Buying a New Car
If you’re planning to buy a new car, you should put down at least 20 percent and the rest of the balance should be financed for no more than 4 years. In addition, you should spend no more than 10 percent of your gross income on transportation costs.
The first part of this rule (i.e. 20/4) prevents you from owing more than the car is worth as it eliminates the additional interest expense that you would incur had you not put down at least 20 percent and had you not financed for a maximum of 4 years as you are paying a depreciating asset. The last part of the rule (i.e. 10) prevents you from buying more car than you can afford.
The 10-Year Rule on Buying New vs. Second Hand Car
Are you torn between deciding whether to buy a new versus second hand car? We all know that a car is a depreciating asset and so if you decided to buy a new car, the 10-year rule states that you must use it for 10 years to maximize and optimize its value. Just remember that while using it, take good care of it so you would not incur a lot of maintenance costs along the way. If you don’t have the intention to use it for 10 years, then save yourself some costs and just buy a good condition second hand car.
The Income Rule, 20% Rule and 28% Rule on Home Ownership
A home is no doubt one of the most expensive items that we will have during our lifetime. It is therefore a must for us to plan ahead before we buy our home.
The Income Rule states that you should not buy a home that is worth more than 2 and half years worth of your annual gross income. If you are married, then it should be the combined annual gross income with your spouse. The 20% Rule states that you should put at least 20 percent down when buying a home. A 20% down would put you to a good credit with the bank. It will give you smaller monthly mortgage which means more affordable payment for you. In addition, it will save you up on interest expenses over the life of the loan. So remember before you buy a home, it would be best to save up 20% for down payment.
The 28% Rule can be applied to monthly mortgage payment. It states that your monthly mortgage payment should not exceed 28% of your gross monthly income. This is a good ballpark figure on how much home you can afford considering other expenses.
Most of these financial rules of thumb are tried-and-tested methods in planning your finances. . These rules are a good starting point. However, personal finance is, always personal. There is no rule that fits all because we all have different financial goals and needs.