financial rules of thumb

Our lives are filled with financial decisions ranging from how much to take out in student loans to what we should spend when buying our first car or home. It seems like such a simple process when they run your credit and say, “this is how much house you can afford!” But these loan officers are not always in a position to be looking out for your best interests, they are representatives of the company that is going to be loaning you money and they want to ensure you have the ability to repay the company. So how do you know what is best for you when you’re working towards a specific goal or you need to make a major purchase? These rules are not exact by any means but they are a great guide to help you avoid dumb money mistakes.

Home Ownership

When taking out a mortgage, the balance should be no more than two and a half times your gross annual income. So that means if your family’s annual income is $100,000, that balance on your mortgage should be $250,000 or less. The bank will most likely approve you for much more than that as they only look at your debt to income ratio and not your average cash flow and spending habits. 

Car Buying

If you can, it’s always better to buy a newish used car and to drive it for 7 to 10 years OR until the wheels fall off! Well that last part may not be a good idea but the point is that used cars still have a lot of value to use up and you don’t want to be the knucklehead who buys a brand new car only to lose 20% of the value the moment you drive it off the lot. If you need to finance the purchase, remember 20/4/10. Put 20% down, finance the car for no more than 4 years, and keep the payments at 10% of less of your gross income. So on a $40,000 used vehicle it would mean you put $8,000 down (whether that means with cash or a trade in), and assuming you finance it for 2% for 48 months that $695 payment means your income needs to be $70,000 or more.

Debt-to-Income

Your debt-to-income (DTI) ratio is one important measure of your financial stability especially if you’re looking to buy a home. You calculate it by taking your total monthly debt payments and dividing it by your gross monthly income. Experts typically recommend that this number be 36% or less. The smaller the percentage, the less debt obligations you have; anything above that can cause financial distress. I personally calculate this ratio using net monthly income as it is a more accurate representation of your spending abilities (you can’t spend the money they withhold for taxes for example).

Insurance

Insurance should only be in place for catastrophic events, not the little things that you can pay out of pocket. Life insurance should be at least 5x your gross income, at a minimum, more if you have other goals you want to accomplish such as ensuring your kids can go to college. Focus on building your savings so you can afford to have higher deductibles and lower premiums. The more risk you can cover yourself, the less you have to give away to the insurance companies for a policy you may never use!

Budgeting

This is where financial security begins! If you don’t have a budget in place or you have a hard time following it, now is the time to figure out how to fix it! A good budgeting trick is to stick with the 50/20/30 rule. 50% of your net income should be allocated to necessities (housing, food, utilities), 20% should go towards financial priorities (saving, paying down debt), and 30% is yours to have fun and enjoy life (shopping, dining, travel). 

Investing

When you’re investing in the markets it can be quite intimidating but all you have to remember is to diversify and keep costs low. Investing is something you can do on your own or through an advisor and if you’re working with an advisor don’t be afraid to address the costs. When it comes to diversification a good rule of thumb is to subtract your age from 120 and that should tell you the percentage of your portfolio that should be in stocks. So if you’re 27 that means 93% of your investments would be in stocks, and 7% would be in bonds.

Retirement

Between saving into your 401(k) or other employer plan, along with employer matches, you should be looking to save 10-15% of your gross income into retirement savings. If you’re reading this and don’t know whether you’re on track with your savings know this, a 30 year old should have at least 1 year’s worth of their salary already saved in retirement, a 35 year old should have 2 times their salary saved. Make sure you don’t fall behind and if you are, find ways to save more!

 

 

 

Disclaimer: I am a CERTIFIED FINANCIAL PLANNER TM (CFP®), but I am not your CFP® or financial advisor. The information in this article is for general informational and entertainment purposes only and does not constitute financial advice. This article does not create a financial planner-client relationship. The author is not liable for any losses or damages related to actions or failure to act related to the content in this article. If you need specific financial advice, consult with a licensed financial advisor, CFP®, or tax professional who can tailor advice regarding your specific circumstances. Additionally, sometimes I use affiliate links to support my website. This means I may earn a small commission, which is no additional cost to you, for referring and discussing products and services that I personally use, or have used and trust. Thanks for your support!