18 Favorite Financial Rules Of Thumb
18 Favorite Financial Rules Of Thumb (and some useful money guidelines)
By J.D. Roth May 2018
Financial Rules of ThumbAfter twelve years of reading and writing about money, I’ve come to love financial rules of thumb.
Financial rules of thumb provide helpful shortcuts for making quick calculations and decisions. You don’t always have time (or want to take the time) to create elaborate spreadsheets when choosing a course of action. In these cases, it’s nice to have some rough guidelines you can rely on.
You’ve probably heard of the “rule of 72”, for example. This shortcut says that if you divide 72 by a particular rate of return, you’ll get the number of years it’ll take to double your money. If your savings account yields 4%, say, it will take about 18 years for your nest egg to increase by 100%. But if you were able to earn 12% on your investment, that money would double in six years.
Like all rules of thumb, the rule of 72 isn’t precise. It doesn’t give an exact answer but a ballpark figure. Financial rules of thumb don’t always hold true. But they’re true enough for us to make loose plans based on them.
I have some engineer friends who’d get tense at this sort of sloppy guesswork, but most of the rest of us are happy to trade a bit of precision for speed. That’s what rules of thumb are all about! The trick, of course, is knowing which rules of thumb to use. Most are handy, but some common guidelines do more harm than good.
Rules Gone Wild
In the past, you’ve probably seen my rant about some of my most-hated financial rules of thumb. Let’s look at three things I think conventional wisdom gets wrong (and what I believe are better alternatives).
How much should you save for retirement?
For instance, I get frustrated when I hear financial advisers push the idea that you should base your retirement savings on 70% of your income. Instead of estimating your retirement needs from your income, it makes far more sense to base them on spending. Your spending reflects your lifestyle; your income doesn’t.
I think a better rule of thumb for determining retirement needs is this: When estimating how much you’ll need to save for retirement, assume you’ll spend as much in the future as you do now. Use 100% of your current expenses to calculate your retirement spending. (And if you want to build in a safety margin, base your future needs on 110% of your current spending.)
How much should you spend on a house?
As I mentioned last week, another rule of thumb that makes me cranky is this common guideline espoused by all sectors of the homebuying industry: “Buy as much home as you can afford.” No no no no no! Of all financial rules of thumb, this is probably the worst. It’s certainly one of the most prevalent. This is how folks end up house poor, chained to a mortgage they resent.
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