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30 Personal Finance Rules of Thumb





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:

  1. 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]
  2. 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.]
  3. 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.]
  4. Maximum mortgage payments should be no more than 28% of your gross monthly salary. [I think this is what the banks use.]
  5. Maximum for all debt payments should be no more than 36% of your gross monthly salary. [Again, I think this is from banks]
  6. 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.]
  7. 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.]
  8. 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]
  9. 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.]
  10. 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!]
  11. 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]
  12. Buy used and drive it for at least 10 years. [Sure, this will probably save a lot of money]
  13. 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]
  14. 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]
  15. 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]
  16. 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?]
  17. 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.]
  18. 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.]
  19. When traveling, take twice the money and half the clothes you think you will need. [Yup]
  20. 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??]
  21. 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?]
  22. 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]
  23. 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]
  24. 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.]
  25. 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.]
  26. 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.]
  27. 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.]
  28. 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?]
  29. 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.]
  30. 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 





47 Comments, Comment or Ping

  1. 1. Traciatim

    Just to let you know in Canada number 30 is not true. If you look at the pump they will all say “Volume Corrected to 15C”, this means that no matter what the temperature you’re getting the same amount of gas as if it in fact were 15C.

  2. #1 is not realistic anymore. The average price in BC is 400K to 500K… I can you expect to have an average income of 100K + in a province?

    #12; I’m not too sure about this one. It’s been 6 years I have my car and I almost put the equivalent of my car payment in garage expenses last year… plus the time I lost going to the garage…

    #17 I say you buy a big freezer and you buy in bulk in order to save money :-D

  3. #1. My rule of thumb is the MORTGAGE shouldn’t be anymore than 2 times family income. If it is, then the family needs to save more cash.

    FB, what type of used car do you drive? BMW? Perhaps thats the reason why your car costs so much to fix?

  4. Interesting post. That photo looks familiar! :)

    I don’t think #6 really holds true in reality – in theory variable should be cheaper but if you are a hard core PFer then you aren’t going to have a mortgage “for the long run” so it may not make much difference either way.

    #10 – I don’t agree with this one.

    #18 – I changed both my house and car insurance to $1000 deductible and saved something like $20/month each.

    #21 – I don’t like taking my car in when the mechanics have nothing to do because then they will “find” all kinds of problems with your car.

    in Germany, they are required by law to turn their cars off at red lights

    I’m going there this summer so thanks for the info!

    Mike

  5. 5. Traciatim

    Hey FB, I’m with you on the 10 year thing, I purchased my 2002 Ford Taurus in 2004, I plan on keeping it until 2012. Last week on Monday I put 2600 in to suspension, tires, brakes, and wheel bearings. Last week on Thursday the oil pump failed destroying the engine and is now in the shop getting 3600 in work to have that replaced. That puts my total for maintenance over the 4 years of owning it near 10K and I purchased it for 12.6K.

    After this I’m saving for a large down payment on a new car possibly in 2012 or a one year old used car that’s in immaculate shape.

  6. 6. Nicolas

    Good list.

    29. Ethanol fuel creates less pollution but takes twice as much energy to produce and is responsible for the huge rise in international crop prices. So think about this one.

    Nicolas

  7. 7. MunEconomist

    I really like the 20/4/10 rule for buying a car.

  8. Interesting list – it could certainly serve as fodder for your next 30 posts as we dissect each of them. :)

    Re: #10 – it would imply that anyone under 20 should be leveraging to get more than 100% exposure to equities. :) Don’t know if that’s the best way to get your feet wet in investing…

    It’s funny, I’ve seen those “100 minus your age = equity exposure” rules of thumb before and you are right – they are just rules of thumb. The paradox is that this rule of thumb is for those who might look for quick and easy rules because they are not inclined to learn about investing – strangely, they might be the worst candidates to start with high levels of equity exposure since they will not have the same understanding of risk/return, volatility, etc to stick with this rule of thumb. Hence, if they lose money and abandon the rule, they will most likely have gotten out at the wrong time – the rule of thumb may have hurt them more than helped them.

  9. Lots of food for thought, although I think I’d have an aneurysm if I was to try to remember them all.

    I don’t think #1 is unreasonable, I live in not-inexpensive Toronto and meet it; if not, continuing to rent is still an option, despite what our parents and the general culture tells us.
    I hate that rule #2 (actually I’m none too fond of the whole book) can we add the standard “if you’re older than 40″ or something to it?
    I also think #8 is really low, how can you save for travel, home maintenance, gifts, emergencies with only 10%? But maybe I’m missing something, I usually am.
    All the contortions required to purchase a car make me even more glad to have never done so.

    (Nicolas, you must have read the same Macleans article I read on the subway this morning. Thought it was really interesting. Scary though, huh?)

  10. I don’t think #6 really holds true in reality – in theory variable should be cheaper but if you are a hard core PFer then you aren’t going to have a mortgage “for the long run” so it may not make much difference either way.

    Given the rate cut this morning – I could be wrong about this one… :)

  11. 11. Telly

    Yay! Looks like I’ve been given the ok to buy a new car next year when my car turns 10! ;)

    Great list – definitely some new ones here!

  12. 12. nobleea

    The photo shows the money FT said he would pay me to write this post. I made it long to make him feel like he got his money’s worth.

    4P: thanks for the info on deductibles. that would be a significant drop (%-wise) for me. I’ll look in to it.

    Traciatim: If I recall the whole flow meter thing, you are getting the same mass at any temperature, but the volume is different as the density changes with temperature.
    see sec. 3.1 & 3.2
    http://www.omega.com/techref/flowmetertutorial.html
    It implies that gas pumps in the US are not calibrated for temp and are true flow (volume) meters, but those in Canada are compensated for temp (inferred mass meters). In theory it *should* be a moot point since the gas is stored underground where the temperature is more or less constant.

    I wish more cities would pass no-idle laws where you have to turn your engine off if you’re not moving. I’m sure eventually car manufacturers will design cars that they do this automatically (Mazda was working on a really neat technique for this).

    Now that I think about #14, I think it only applies to new vehicles. Someone could pay $10K for a used car and would easily spend more than $167 (or $83 as I suggested) per month keeping it running. Yet, if you were to get a new 50K car, it’s going to cost less than $833/month (1/60th) to keep it running. Sure, the absolute number is higher, but the ratio is lower.

    #10 rule of thumb is just that. I don’t think many 20 yr olds think much about investing and getting the right asset allocation (those that do won’t follow rule of thumbs). As WDAMMG pointed out, those who follow this rule of thumb would be most likely to bail at the wrong time. But I think that would be the case if they had half of the equity exposure they were supposed to. The rule of thumb just says you should have so much % in equities at X age. If you follow that, then its a good start.

  13. Nobleea, Canadian money does look a lot like Monopoly money doesn’t it? ;)

    Thanks again for the post, it is very much appreciated.

    Telly, are you looking at buying a new car next time around?

  14. 14. FearLES

    You don’t have to turn your car off at red lights in Germany but you do in Switzerland (if you are more that 3 cars back from the front or something) and at railroad crossings.

  15. 15. assibatzen

    “I know in Germany, they are required by law to turn their cars off at red lights.”

    I’m German, but I never heard of that. It’s forbidden by law to let your car idle in the winter time and than go grocery shopping and remote car starter are not allowed either, i believe. No one ever turns it’s car off at a red light. Maybe there is a law, but it might not be enforced.

    keep up the blogging!

  16. 16. nobleea

    I stand corrected. When we were in West Germany (we lived in Belgium about 18 years ago), the traffic lights would go from red to yellow to green (rather than red to green) to let drivers know to start their cars. It might have been only in a couple cities. I was only in grade 4!

  17. Nobleea and FT,

    Thanks a lot for the list. It is really interesting. However, I do not agree about #10. I strongly believe that 15-20% is the maximum amount of bonds a retired investor should hold. If you were 70, you will be holding 50% in bonds. Inflation would slowly eat your nest egg, because you will be a net seller of stocks in good and bad times.

  18. 18. supersocco

    I remember Europeans turning their cars off at a train crossing back in the 80′s. I feel like I am the only one that ever does it here.

  19. 19. squawkfox

    I’d like to add to “#11 Student Loans.” Before taking on student debt one should consider if the subject of study makes sense considering the size of the loan. When taking on education debt many students fail to consider if the subjects they study can bear the financial burden of debt repayment. Don’t make me list a bunch of low-paying subjects. ;)

  20. 20. Sarlock

    A good set of core rules. Every person should take heed and modify accordingly to suit their own unique personal situation (location, income, etc). As mentioned, your mortgage amount will vary based on where you live in the country… you will be at a much higher ratio in Vancouver or Toronto than you would be in Fredericton, where you can get the same home for 2-3 times less.

    I purchased my car new for the reliability factor. I paid a premium for the purchase, but reliability has a value as well. I am happily paying a few extra dollars to know that my car is much less likely to break down on the highway in the middle of winter at -40 with a young family in the back.

    One worth adding:

    * Dining out is expensive:
    -Cook and eat meals at home
    -Pack a lunch for work

    Dining out is a big killer on the personal finance front. My wife and I cap our dine-out/order-in budget at one meal per month max.

  21. 21. James

    Ive got an issue with #12. My wife and I share a car and it gets about 30-40,000 kms a year as a result. I dont think 10 yrs is reasonable at all. Maybe if I drove 10km to work.

  22. 22. telly

    FT, I have a love / hate relationship with my car. Love that’s it’s paid for but hate that it’s lasting so long (220k km) and doesn’t have automatic windows or locks and no cd player. :( I’ve always said I’d never purchase new again but if I can get 10 yrs and 250k km out of a car that was purchased for < $20k, it might be worth buying new again (with maybe even a few bells and whistles :) ).

    My original plan was to try to get 300k km out of my car but now that I’m car pooling, it’s going to be tough and I think I may cave before then.

  23. 23. DAvid

    “Yay! Looks like I’ve been given the ok to buy a new car next year when my car turns 10! ;)”

    Ummmmmmm….. I think it says buy used and DRIVE it 10 years.

    My experience is vehicles over 10 years old start to become ever more expensive to maintain. So, if you bought a 5 year old car, and expect it to be cost effective for another 10 years, you might be sadly disappointed. Also, once the old car starts costing you anywhere near the monthly cost of a replacement, it is effectively unsalable, so you have no equity against the new one. If you purchase a young used car, you might do OK, but you have to be prepared to exit at any time.

    “#18 – I changed both my house and car insurance to $1000 deductible and saved something like $20/month each.”

    On your house, this may have more value than your car. The break even point seems to be about 42 months, so if you are claim free for greater than 42 months, you win. Here in BC, you lose your windshield deductibility if you choose a higher deductible. Since many of us replace a windshield at least annually, you have to balance this cost carefully. On my current 12 year old truck I’ve replaced 4 windshields and the grill / radiator (deer), so I think I’m about even on the deductible.

    DAvid

  24. 25. YoungEngineer

    Somebody mentioned that Mazda is looking into vehicles that turn off/on automatically to shorten prolonged idling. I was driving a Toyota Prius hybrid last time I rented a car, and with the hybrid technology it essentially did the same thing. As the hybrids are optimized for seamless starting/stopping of both the electric and gas powered engines, the car essentially ‘turns off’ when you come to a stop. I thought it was pretty cool. Only makes sense if the car can run completely on the battery power, why would the engine need to idle while you’re stopped. Just thought I’d mention it.

    As for the rules, I’d have to say the 2-3 times earnings is a tough one to make in a lot of urban markets. I’ve heard about the variable rate argument. With low interest rates, especially with the current cut and the forecasted further cuts, wouldn’t it be ideal to lock in now and forego the rising rates in the future? The way I see it rates can only go up from here.

    I definitely agree with wash your car before servicing. The undercarriage being the most important. Not sure if it makes a difference on whether they gouge you or not, but I’m pretty sure they can have a much better look at things when they’re clean. Not to mention the checklist I got back last time I took it in wasn’t completed fully, with the excuse that the vehicle was too dirty to notice. Won’t happen again though.

  25. FT,
    - If me an my wife would live in BC (we make about 80K combined), we would have to save 240K to buy a regular bungalow 1988 (worth 400K). By the time we save 240K (if we ever save it!), the house would probably worth 550K right? I don’t think this rule will apply in the future.

    When you think about it, 50 years ago, they used to pay their mortgage within 10 years. Today, we see 30 and 40 years mortgage products. It also has to do with our life expectancy.

    - My car is a Mazda, I guess I got unlucky!

  26. 27. 45free

    Hey Frugal,
    Let me know if # 27 holds once the baby arrives! My guess is, the car warms up a little longer!

  27. 28. Warren

    I think the down payment rule of thumb is not far off. Its a big warning that home prices out here in BC are way too high, and destined for a drop. Rents haven’t increased, go ahead and keep renting.

  28. I’m with you Warren. I would rather rent than to have a huge portion of my take home pay go towards my mortgage.

  29. 30. DAvid

    Renting is fine if you can find a place. In our town, there is practically nothing to rent, so if you want a roof over your head, you might have to buy. Housing prices have more than doubled in the past 3 years, so this creates a considerable housing problem!

    DAvid

  30. 32. SB

    Regarding Item 30:

    I disagree with your comment that you are better off buying gas when it is warmer, you are actually better off buying gas when the temperature is colder.

    Volume is independant of temperature, so regardless of the ambient temperature when you buy gas you get the same volume, i.e. 30L is 30L regardless if it is +30 or -30 degrees. However, the volume you purchased will change later if the ambient air temeprature changes.

    At lower temperatures gas will contract, thus the gas has more energy stored in it for a given volume, when compared to the equal volume at higher a temperature. Seeing it is the energy stored in the gas that drives the engine, you are better off buying gas when it is cold because you effictively purchase more energy.

  31. 34. Patrick

    Rule 30 is wrong. It doesn’t matter whether it’s warmer or colder. That’s exactly why they normalize it to a certain temperature. At higher temperatures, gas expands, but it’s the same number of molecules; they just occupy more space. Therefore, you get more litres per dollar, but each litre contains less burning power, and you end up exactly even.

    A full tank of gas will take you farther in winter than in summer, but will cost proportionally more.

  32. Wow, I had never seen #2 until now. If that is the case, I am well behind the curve even though I thought I had been doing very well in my financial life. How many are really at that level?

  33. Need to add the 20% Rule … probably the most important ‘rule’ of them all … it tells you How Much to Pay for a House

  34. 44. Gary

    #13 Remember always buy a used car, something with a good repair history. Check consumer reports ( at the book store for free )

  35. 45. Patrick

    Don’t worry about rule #2. It is patently absurd. It means every time you get a raise, you might suddenly be short on your savings because your denominator has increased. It also implies that your retirement savings grow linearly throughout your lifetime, which doesn’t happen. Consider a 30-year-old man who has been working at his career for 6 years. Rule #2 says that he should have saved 3x his salary by now. That means half of his entire gross salary would need to have gone into savings!

    This rule is fundamentally flawed because how much you need in retirement depends on your post-retirement expenses, not your pre-retirement salary.

  36. 46. Sarah

    Rule no. 2 has always been really confusing for me. I am 23 right now, so I’ve only been working full-time for a little under a year and a half. There should be a qualifying statement somewhere in the book about how this equation cannot possibly apply to people who have been working for < 5 years or so. Even if I saved my entire salary for 3 years, after taxes, I wouldn’t have the recommended amount. I mean, it’s pretty obvious, but still makes me feel bad about my savings.

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