Nobleea has come up with the idea of compiling personal finance rules of thumb into a blog post. He has done the research and has shared with us his findings. Who is Nobleea? He is a regular reader, commenter, engineer, and personal finance enthusiast.
It is often believed that the term ‘Rule of Thumb’ was from earlier times where a man could beat his wife as long as he used nothing larger than his thumb. According to Wikipedia, this has been discredited and the term refers to old carpenters who used their thumbs as measurement tools (or something like that).
It’s time for a post on Rules of Thumb that are somewhat or very financial in nature. I just wanted to list off all the ones I could find and discuss whether they’re relevant. Perhaps you’ve heard of other ones.
I’m sure many will point out that these are very broad and basic rules and are probably too simple for us high-fallootin’ PF bloggers and readers. But that’s the idea behind Rules of Thumb. They’re supposed to be simple and straightforward so that anyone can understand and apply them.
So here are the "Personal Finance Rules of Thumb" that I could find, with my comments in brackets:
- You should spend no more than 2-3 times your household salary on a house. [I think your mortgage should be no more than 3 times your household salary as a maximum. Any equity/down payment you have should be taken into account in this Rule of Thumb]
- In order to retire comfortably at a normal age, your net worth should be your age times your salary, divided by ten. [I don’t remember the footnotes that go with this Rule, but it is from The Millionaire Next Door. If your net worth is twice that number or more, then you are a Prodigious Accumulator of Wealth and you’ll be very comfortable in an early retirement. Discuss.]
- Every dollar in your RRSP in your twenties corresponds to a dollar of yearly income after 65 (adjusted for inflation). Every $2 in your RRSP in your thirties corresponds to a dollar of yearly income after 65 (adjusted for inflation). Every $4 in your RRSP in your forties corresponds to a dollar of yearly income after 65 (adjusted for inflation). Every $8 in your RRSP in your fifties corresponds to a dollar of yearly income after 65 (adjusted for inflation). […Until at 65-ish, you should have around $25 in your RRSP for every dollar of income (equates to 4% withdrawal rate). I can’t remember what the assumptions were. But not hard to figure out I guess…Using the rule of 72, it implies a real return of 7.2% in your RRSP. Perhaps a bit high, but not completely unreasonable.]
- Maximum mortgage payments should be no more than 28% of your gross monthly salary. [I think this is what the banks use.]
- Maximum for all debt payments should be no more than 36% of your gross monthly salary. [Again, I think this is from banks]
- If you negotiate a discount of prime, a variable rate mortgage will always be cheaper in the long run when compared to a fixed-rate mortgage. [I think this is true.]
- Pick a variable rate mortgage, but increase your payments so that they match the fixed rate payments. [This one is from Gordon Pape I think. Gives you a safety cushion if rates go up, and you’re prepaying the mortgage if rates stay the same or go down.]
- In addition to maxing out your retirement plans, try to save at least 10 percent of your take-home pay for other goals, such as an emergency fund, college or a new home. [Makes sense, a lot of PF books have said the same thing]
- Generally speaking, if you've got young kids or teenagers, you'll need a life insurance policy that covers between 6 and 10 times family income and possibly more, depending on your family's expenses and how much your surviving spouse can earn. [I’m sure everyone will point out that it is not income that matters, but expenses.]
- To find the percentage of your portfolio that should be invested in stocks, Subtract your age from 120. This formula should help you maintain your living standard through your retirement years. [The rule used to be 100 minus your age, but people are living longer I guess!]
- Student loans: "Your total borrowing shouldn't exceed what you expect to make your first year out of school." [I don’t know what the basis is for this rule. Should be doable in Canada, unless you take 12 years of university]
- Buy used and drive it for at least 10 years. [Sure, this will probably save a lot of money]
- If you must borrow to buy a car, follow the 20/4/10 rule." Which means: Make a 20% down payment, don't borrow for more than four years and don't agree to a monthly payment that's more than 10% of your income — or 8% if you plan to buy a home in the next few years. [I reckon no one here has heard of the 20/4/10 rule, but there you have it, plain as day. The 20/4/8 rule must be to keep your debt payments reasonable when including the mortgage payment]
- To compute and compare the real monthly cost to buy, insure and operate a car, double the price tag and divide by 60. [I think this rule is way off. Maybe it’s more like 120. Of course, this doesn’t take in to account the amount of mileage you put on the car every month]
- Insure yourself for catastrophic expenses, not the stuff you can cover out of pocket. [Absolutely. Why get extended insurance on a $110 bread maker? Insurance is to protect wealth, not create it]
- If you can't afford to buy the house using a 30-year fixed-rate mortgage, you can't afford the house. [Clearly an American Rule of Thumb. Wonder if it still applies using the standard Canadian 25-yr fixed. And is this based on the posted rate or the negotiated rate?]
- It will save you money if you buy the right size refrigerator-freezer for your family. You need a total of 8 cubic feet of space for two people, plus 1 foot for each additional family member. [That doesn’t seem like a whole lot of space. I know family fridges are around 22 cu ft. So unless these families are meant to have 16 family members, something’s amiss here. Mind you, I have a 22 cu.ft fridge and there’s only a sprinkling of condiments inside. I’m sure a membership to Costco will remedy the situation.]
- As a rule, your collision deductible should equal one week's take-home pay. [If that’s true, then I suspect most people have way too high of a collision deductible. Does anyone know how much you’d save by moving from $500 to $1000 deductible? I vaguely remember a rule of thumb about collision coverage where if you pay more in a year on collision coverage than your car is worth, pass on it. Or maybe it was 2 years. Either way, if the car is 2000 model year or newer it’s going to cost $2500 minimum to fix anything.]
- When traveling, take twice the money and half the clothes you think you will need. [Yup]
- Each degree you lower your thermostat over the winter will lower your overall heating bill by three percent. [Certainly a rule of thumb as the amount of savings will vary as to the temperature difference between inside and out. Wonder if its Fahrenheit or Celsius??]
- The end of April is the best time to get your car serviced because it's the slowest time for auto mechanics. The mild weather makes people feel more confident about their cars, and many can't afford car repairs because they've just paid income taxes. [Hmmm, maybe…Anyone confirm this?]
- Always wash your car before taking it in for service. Mechanics are more likely to take advantage of you if your car looks like it needs "everything." [Find a good mechanic first and you can skip the car wash]
- Cars with four doors are cheaper to repair than cars with two doors, but two-door cars are stolen twice as often as four-door models. [This is probably due to a broad generalization since 2 door cars are more likely to be expensive sports cars]
- The highest price you should pay for a car you're buying with a car loan is one-half your annual gross income. [See the 20/4/10 rule in #6.]
- It pays to turn off your engine if it will be idling for more than one minute. [Definitely. And good for the environment too. I think with newer cars you can cut that time down to 10 seconds. I know in Germany, they are required by law to turn their cars off at red lights.]
- The best time to buy a new car is the last day of the month because the sales staff wants their monthly reports to look good and is more likely to bargain. You can increase your chances of getting a good deal by choosing the youngest salesperson on the floor. [Sounds logical. But when you combine this with the other car-themed Rules of thumb, buying a car seems VERY complicated.]
- The time it takes to clean off the windshield is the time it takes to warm up your engine. [Agreed. Even from -40C with no block heater, all the engine needs is 30 secs maximum. On a regular winter day, I give it about 10secs, assuming there’s no snow to remove. The cab will heat up much faster if the engine is actually working, and it doesn’t work too hard when sitting and idling.]
- When traveling under 50 mph, it is more efficient to drive with the windows open than with A/C on. Above 50mph, it is more efficient (and comfortable and quiet) to drive with the A/C on. The drag is much worse with the windows open at higher speeds. [I think this is true. Didn’t Mythbusters do a show on this?]
- Ethanol stores about 2/3 the energy of gasoline. Therefore, a 15% ethanol blend will reduce your mileage by 5%. [I think it decreases the harmful NOx emissions, so maybe it’s a wash? Probably not.]
- There is a good rule for what temperature to buy gasoline at (the pumps are calibrated at a given temperature, 15C usually). Buy it above that temperature and you'll get more for free, buy it below that temperature and you'll get less than the pump says (why you can sometimes fill a 60L tank with 62L). [I just made this one up. But I do recall this discussion from a course on Engineering Measurements. Something to do with the density change affecting the flow meter.]
Well, I think 30 Rules of Thumb is enough for now. I’m sure everyone’s got another goofy one they’ve heard of.
Note that these rules of thumb are very broad, generic and probably don't apply to your situation. Please don't take these rules of thumb as advice!
photo credit: rick
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