Buzz
Financial principles are an excellent starting point for getting your money organized. To help you, we’ve outlined ten essential tips. However, since everyone's financial situation differs, we’ve also highlighted scenarios where each rule applies best.
Creating a Budget
The 50/30/20 Budgeting Formula
This budgeting method is quite popular. The 50-30-20 rule suggests allocating 50% of your income for essentials such as housing and utilities, 30% for discretionary spending like dining out and entertainment, and 20% towards financial goals such as debt repayment or saving for retirement.
There are alternative variations of this rule, such as the 80-20 rule, where you allocate 20% of your income to your financial goals, leaving the remaining 80% for all other expenses.
Why it works: If you're unsure how to begin budgeting, dividing your finances into these simple categories can be very effective. The percentages offer a balanced approach, helping you manage obligations, goals, and indulgences.
When it doesn’t: If your income is limited, you may not have the flexibility to spend only half on necessities.
You can always create a budget tailored to your specific needs—start fresh and follow these budgeting steps to craft a personalized financial plan.
Purchasing a Vehicle
The 20/4/10 Rule
When purchasing a car, aim to make a down payment of at least 20%, limit your car loan to no more than four years to avoid excess interest, and ensure that transportation expenses don't exceed 10% of your gross income.
Why it works: This rule helps prevent you from buying a vehicle beyond your means. Cars can be costly to maintain, and this guideline considers all ongoing transportation expenses, including your car payment, parking, fuel, and insurance (which varies depending on the vehicle).
When it doesn’t: Depending on your circumstances, these figures may not be practical. For instance, you might spend over 10% of your income on transportation due to a long commute with a fuel-hungry vehicle and a low-paying job. If your car is essential for work, you might need to make adjustments in other areas of your budget.
The 10-Year Rule
This rule helps you decide whether to buy a new or used car. To get the most out of your car’s value, you should either opt for a used car or buy a new one and keep it for at least ten years.
Why it works: This approach reduces the impact of depreciation. New cars lose 20% of their value in the first year, according to Carfax. On the other hand, buying a used car allows you to avoid that initial depreciation hit. If you choose a new car and hold onto it for a decade, you’ll have made the most of its value, and depreciation will matter less.
When it doesn’t: Used cars are more prone to breakdowns and might require costly repairs. You’ll need to ensure that the repair costs don’t outweigh the benefits of sticking with a used vehicle.
In general, it’s important to do thorough research considering all factors. Edmunds offers an affordability calculator, and we’ve also written about the four essential questions to ask when choosing between a new or used vehicle.
Homeownership
The 20% Down Payment Rule
When purchasing a home, it's recommended to make a down payment of at least 20%.
Why it works: This strategy helps you avoid overextending yourself by purchasing a home that's beyond your budget, reduces your monthly mortgage payments, and can improve your chances of securing loan approval. Additionally, you won’t be required to pay private mortgage insurance.
When it doesn’t: While this is generally accepted advice, some people find saving 20% for a down payment to be an unrealistic goal due to the significant amount of money required.
The Income Rule
Avoid purchasing a home that exceeds three times your gross annual income. Some variations suggest a limit of two years' worth of income, while others recommend two and a half years.
Why it works: This rule provides a general estimate for how much house you can realistically afford based on your income.
When it doesn’t: This rule doesn't account for how much money you have saved or invested, so it may be more useful to evaluate your net worth rather than just your income. Also, in large cities with higher housing costs, this rule might not apply if the property offers long-term investment potential.
These general guidelines give you a rough idea of how much you can afford when considering homeownership. However, there are additional costs to factor in, such as closing costs, and the total expenses can vary. Be sure to check our list of homeownership expenses that you might miss before starting your home search.
Retirement
The 10% Rule
A common guideline is to save 10% of your income for retirement.
Why it works: This rule provides an easy starting point for people. If you're young and new to retirement savings with a 401(k), setting aside 10% of your earnings is a reasonable place to begin.
When it doesn’t: While saving 10% is straightforward, this rule doesn't take into account how much you’ll actually need in retirement. It also doesn't consider your current savings. If you're behind, you'll likely need to save more than 10%. Likewise, if you aim to retire early or live a more luxurious lifestyle, you'll need to save beyond the 10% mark.
The Income Rule
Aim to save an amount equivalent to 20 times your gross annual income for retirement.
Why it works: This guideline helps you estimate the financial security you'll need to support your future lifestyle.
When it doesn’t: This rule is more of a general starting point than a one-size-fits-all solution. Your retirement expenses could differ greatly from your current income, and depending on your desired lifestyle, you may need more (or less) than 20 times your income.
While these rules provide a rough estimate, for a more tailored approach that factors in all variables, create a detailed vision of your retirement and then calculate the cost of the lifestyle you wish to lead.
Student Loans
The First-Year Salary Rule
You should never borrow more for student loans than what you expect to earn in your first year after graduation.
Why it works: This rule helps ensure you're taking out an amount of student loans that is manageable and repayable based on your anticipated income.
When it doesn’t: Rising tuition costs and the uncertainty of securing employment right after graduation have made this rule harder to follow.
This is a complex and often controversial subject. With the student debt crisis and the ongoing recession, it's tempting to overlook this rule. However, it's crucial to realistically assess what your future income and repayment situation will look like after graduation, particularly in relation to your major. Additionally, it’s helpful to compare the cost of an education at various institutions to get a clearer picture of what you can afford.
Saving and Investing
The 6-Month Emergency Fund Rule
You should set aside enough money to cover six months of living expenses in case an emergency occurs.
Why it works: Having this safety net is incredibly beneficial when unexpected events arise. It ensures you're not forced to make desperate decisions that could harm your financial future.
Why it doesn’t: There are numerous perspectives on how much you should save, but as we saw with the pandemic, even this amount might not suffice.
It can be tough to hear the advice 'save for an emergency fund' when you're struggling financially, so with that in mind, here's a Mytour post offering alternative ideas for securing emergency cash.
The Age Rule for Stocks
When investing, bonds tend to be less volatile than stocks. The general rule suggests that as you age, you should reduce your stock investments. To determine how much of your portfolio should be in stocks, subtract your age from 120 (the old rule was 100, but many experts now agree that 120 is a more appropriate figure).
Why it works: It provides a rough guideline for how to allocate your assets, based on your age.
Why it doesn’t: This rule overlooks the exceptionally low interest rates we've faced in recent years. It also assumes a retirement age based on your current age. If you're aiming for an earlier retirement, you'll need to make adjustments.
To better understand how to balance your savings between stocks and bonds, you might want to try online tools like Portfolio Visualizer or Personal Capital, which can help you map out your retirement strategy.
Many of these guidelines are solid, proven strategies for managing your finances. However, personal finance is inherently personal. Consider these rules as a foundation—proper financial management requires research and tailored planning.
