There are quite a number of useful rules of thumb that you can follow to kick-start your financial planning process. Since everyone’s situation is different, you can use rules of thumb as a general guide. They help make good estimates or approximations in making financial decisions such as how much to save, or how much debt can I have. There are no concrete financial numbers that can define one’s success, but there are some basic rules i.e., rules of thumb, that are widely used to gauge progress and keep one’s finances on track.
To answer the basic financial planning questions on saving, emergency fund, debt, mortgage, retirement and more, here are the most widely used rules in personal finance:
1. Savings
The Balanced Money Formula
The balanced money formula is a budget framework, which breaks down your budget into 50/30/20. According to this rule, 50% of your income goes towards necessities, 30% to discretionary items and 20% to savings (includes debt reduction). This 20% saving rule applies to create a retirement fund, saving for unexpected expenses and paying down debt. The rule works because it helps users categorize spending and balance obligations, goals, and lavish spending. Remember that this rule only serves as a basic starting point for financial planning. Thus, it shouldn’t be taken as the entire gospel. Since we have different strokes for different folks, you’ll need to design something that works best for you.
2. Emergency Fund
X Months of Expenses
To determine how much to set aside for your emergency fund here is a very clever rule of thumb. It states that you should stash away cash for X months of expenses, where X is the current unemployment rate. In other words, because Kenya’s latest unemployment rate is approximately 12%, you should aim to have enough money in your emergency fund to cover 12 months of expenses. Therefore, whatever your current monthly expenses are, save enough to cover one year of expenses. Having an emergency fund not only comes in handy when an emergency arises, but also keeps you from making desperate decisions that could set you back financially.
3. Debt
The 28/36 Rule
How much debt you can have is completely dependent on various factors such as stage of life, saving habits, job stability, and financial obligations. Thus to determine a good debt load, you can consider using the 28/36 rule. This rule stipulates that you should spend no more than 28% of your gross income on home-related expenses such as mortgage payments, property rates and other fees, and a maximum of 36% on servicing debt. This also includes housing expenses and other debts such as car loans or credit cards.
For instance, if you have a household gross annual income of KES 4.5M, then your mortgage, property rates should not exceed KES 1.17M (26% x KES 4.5M) per year. Furthermore, your total debt payment should not exceed KES 1.62M (36% x 4.5M) per year, including mortgage payment. Remember, this is just a rule of thumb and therefore, just a guideline you can use when shopping for a new home. In reality, your specific financial situation will determine what type of home and mortgage payment will best work for you.
4. Mortgage
The 20% Rule
Placing a 20% down payment for a house has significant financial benefits. For starters, it will lower your monthly mortgage payments and lower the overall mortgage cost. Though it may be difficult to raise the initial amount, it is worth the shot if you have the money. However, I wouldn’t recommend giving up your liquidity or savings to meet the requirements of this rule.
5. Retirement
20 x Gross Annual Income Rule
When deciding how much you should save for retirement, one basic rule of thumb is to save up to 20x your gross annual income. This means that upon retirement, you should have at least 20x of your gross annual income in a retirement fund. Although, you’ll traditionally set aside about 10% of your income every month, ensure that by the end of your work duration, you have enough to live on. This rule works well because it focuses on your future spending needs. Keep in the mind, that your spending habits upon retirement may differ, depending on the lifestyle you plan to live or future needs.
To ensure that your retirement corpus outlasts you, then withdraw no more than 4% from your retirement account. This way you can preserve your capital and keep a good steady income flowing through retirement.
Read More: How to Produce Income From Investing Forever
6. Inflation
Rule of 70
Inflation is the silent killer for most savings and investments. The rule of 70 is great for predicting your future buying power, particularly upon retirement. It specifically seeks to determine how fast the value of your investment will get reduced to half its present value. With the rule of 70, we divide 70 by the current inflation rate. In other words, because Kenya’s inflation rate has an average of 6.8% over the last 7 years, then it will take 10.3 years ( 70/6.8) to reduce the value of your money to half.
7. Investment
Rule of 72
For those looking to double their money, then the rule of 72 will help you determine how long it will take. Since the current interest rates on savings in Kenya is about 7%, then it will take about 10 years (72/7=10.3) to double your money. To triple your investment use 114 and to quadruple use 144. This rule is great as it provides a great estimate, for those serious about doubling, tripling or even quadrupling their investments.
8. Net Worth
Target Networth Rule
It is important to keep in mind that there is no single rule of thumb that is perfect. So here is a formula to determine how much your net worth should be. It was used by Thomas Stanley & William Danko in the book the ‘Millionaire Next Door’. The book studies self-made millionaires in America and presents this formula to help you determine if you are one. The equation reads, net-worth = Age x Pretax Income divide by 10 – in the case where your annual pretax income is KES 4.5M at 27 years of age, then your net-worth will be about KES 12.15M [(27 x 4,500,000) ÷ 10] – which may turn out to be high or low for some. But even with that, I would only recommend using this equation to determine your net-worth goal, where you can try to match, double the target, or do better.
Summing Up
These rules are great as they give great estimate figures of the ‘how much’ questions. They also serve as a great guide to making various investment decisions for those seeking to achieve financial freedom. However, if you want a more tailored and more detailed complex picture, consider more life variables or engage the services of a financial planner. Other than that, just move on to calculate how much that lifestyle will cost and determine what actions you’ll need to take today.
Image credits: Top, by Raw Pixel via Pexels.
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