Personal Finance Thumb Rules
Last few years reading on personal finance gave me several “Thumb of Rules” which I wished I would have collected somewhere for easy reference later on, and to pull easy reference during several discussions on such topics. Such thumb rules are, by definition, not meant to give you exact answers but its purpose is to give a near correct answer with easy enough to understand and remember.
Because thumb rules are easy to remember, it serves as an easy reference for anyone’s personal decisions. Whether he/she is a beginner in personal finance journey or already a professional planner, everyone can pick such rules and draw easy numbers/decisions.
“It is better to be roughly right than precisely wrong.” — John Maynard Keynes
Above quote gives full justice to thumb rules and their purpose. So keeping this quote in mind, here I jot down few important thumb rules which I have collected till dates. I wish to keep this article updated with any new thumb rule I find which gives a good sense of understandability, easy enough to remember and provides unique personal finance ideas.
Let’s start jotting them down.
Rule of 72
The Rule of 72 is a simple formula to determine the amount of time an investment would take to double, given a fixed annual interest rate. To use the rule of 72, divide 72 by the annual rate of return and that’s an approximate number of years to double.
For example, If your investment gives you 4% annual interest then you expect to double your investment in 18 = 72 / 4 years. By the way, that’s your sleeping money’s rate of growth in India. :)
There is a further variation of Rule of 115 and Rule of 114, the idea remains same but these rules help us calculate the time it takes to triple the money. And Rule of 144 is for quadruple, with the same idea.
All of the above rules can be used to calculate reverse effect too, that is, how much time inflation will take to erode the value of money. For example, with 8% inflation, it will take 9 years to cut down the half purchasing power of current money, as per Rule of 72.
The 10 / 5 / 3 Rule
“The 10/5/3 Rule” is simple to set our long-term expectations of returns from assets. It indicates 10% long-term average returns from Equity, 5% from Debt (FD / PPF / Bonds) and 3% from Cash in Bank and Cash Equivalents. Considering Indian context it could be considered 12 / 7 / 4 as of now, but as country matures we may end up with 10 / 5/ 3 figures.
The 50 / 20 / 30 Rule
“The 50 / 20 / 30 Rule” indicates how should we spend our money, left after servicing our loan EMSs. As per the rule, 50% of income should be spent on Essentials like monthly bills, grocery etc. 20% should be invested for short term and long term goals. And 30% should be Personal expenses like Movies, Leisure activities etc. As you get more control on your expenses, it is expected you will move more money towards your goal bucket but these numbers should be the bare minimum to keep your neck above water.
The 20 / 4 / 10 Rule
“The 20 / 4/ 10 Rule” helps us on Car buy. As per rule, we should be ready to write cheque for 20% amount of car as down payment, tenure of loan should not exceed 4 years as that’s the typical duration when person’s life cycle changes hence demand for car changes, and expenses on car (Fuel cost, Insurance, Loan Principal + Interest) should not exceed 10% of annual income.
100 Minus Your Age Rule
100 Minus Your Age rule is also known as “Age-based Asset Allocation” and “Constant-Weighting Asset Allocation” in financial jargons. It has been covered in detailed in my earlier post of “Benefits of Asset Allocation”. Please read that article, anyways here I will attempt to explain it in brief. As per the rule, you should have an allocation to Debt assets equal to your age number of percentage, and remaining (100 — Age) percentages should be in Equity. For risk-averse investor 100 as a number is good enough, but someone who can digest more risk should use 120 as a number to calculate Equity portion first and remain gets allocated to Debt portion. Many people think this rule should officially be changed to 120 Minus Your Age Rule.
“4% Withdrawal” Rule was invented by William Bengen, wherein he suggests that if we withdraw up to 4% of retirement corpus in a year during retirement then we can live without fear of NO money during our retirement life. Considering rule was invented more than three decades back in USA, in current times of high inflation rates and low assured returns in India, living on 4% may not be acceptable and attainable so it could be tweaked to 5% (William himself tweaked it to 4.6% in 2006 a decade back as per his Wikipedia page) and situation demands higher allocation to equity portion as life expectancy has improved due to medical advancements, hence the above 100 Years rule also demands 120 number.
Are You Wealthy?
A simple formula developed by Thomas J Stanley in his book The Millionaire Next Door indicates whether one is wealthy or not. Formula is (AGE x Pre-tax Income) / 10 = Required Net Worth. If your Net Worth is more than above calculated Required Net Worth then Congratulations, you are a wealthy person. If not, then buckle up and plan to increase your earnings, because Age is always increasing number so your Required New Worth will always increase. There is one catch on this rule, in case your pre-tax income decreases then formula might indicate you being a Wealthy person but you know the fact, so it is assumed that pre-tax income will not drop drastically.
Below are few trivial one-liner rules, which do not need much explanation.
- Whom should you pay first on salary day? YOURSELF.
- Retirement should be the first priority, even before child education and child marriage.
- Magical Retirement Need Number: 30x Annual Salary. Higher the better.
- Minimum Emergency Fund: 6 Months.
- Magical Life Insurance Number: 10x Annual Salary.
- Home Loan EMI should not be more than 40% of monthly salary.
- All Loan EMIs sum should not be more than 50% of monthly salary.
- Consider buying Home only when you can write a cheque for 25% amount of Home Value. 20% for Down Payment and 5% for Initial Setup (Furniture & Electric Fixtures).
- Know your risk capacity before making an investment.
- Buy on Credit Card only if you can pay in full by next month salary.
- Short term goal should have investments in Debt or Liquid funds and Long term goal should have investments in Equity.
I have tried to jot down most of the thumb rules of personal finance I knew. I am sure I have missed few, should you find any which should have been noted on this article then please drop a note in the comment section, I will surely include it.
Image Credit: NJ Webnest
Originally published at The Simple Personal Finance.