We found five rules that you may want to bendâor ignore.
By Pat Mertz Esswein, Associate Editor
May 9, 2019
From Kiplingerâs Personal Finance
Financial rules of thumb circle around the internet like flotsam caught in an eddy. We scrutinized five particularly persistent ones to see how they hold up. Our conclusion: Most have merit as a starting point for setting a financial goal. But depending on your personal circumstances, you may benefit from bending the rules.
In her 2005 book, All Your Worth: The Ultimate Lifetime Money Plan, Elizabeth Warren, then a Harvard professor, presented âthe balanced money formula,â which has since been popularized as the 50/30/20 rule. Under this rule, you allot 50% of your take-home pay to âmust haves,â 30% to âwantsâ and 20% to savings.
Must haves include housing, utilities, medical care, insurance, transportation, child care and minimum payments on any legal obligations, such as student loans, child support or anything for which youâve signed a long-term contract. Why only 50%? Warren says itâs sustainable, leaving you with plenty of money for the rest of your life, including fun and the future. When things go wrong, you may be able to cover the basics with an unemployment or disability check or, if youâre married, live on one paycheck for a while.
The 20% for savings is automaticâdebited directly from your paycheckânot an afterthought. Use the money to build an emergency fund, pay off debt and save for retirement.
That leaves 30% of your budget for your wants (including charitable giving), which allows you to avoid the cycle of binge spending and crash-diet budgeting, writes Warren. If something goes wrong, this category is the first place you cut.
Although 50/30/20 is a good guide, you need to be flexible, says credit expert Gerri Detweiler. If you live in a high-cost area, spending more than 50% of your paycheck on living expenses may be unavoidable, given the cost of housing, child care and health care. Similarly, if staying within the threshold means buying a home that comes with a three-hour-a-day commute, you may choose to stretch beyond the limit to live closer to work and have more free time. If youâre carrying high-cost, unsecured debt, Detweiler strongly recommends that you pay it off within three years to avoid digging yourself into a deeper hole. She recommends that you apply a portion of the 20% designated for savings toward debt repayment and consider how you could reduce your living expenses or discretionary spending to meet the goal.
Itâs also important to reevaluate your budget periodically as your life changes. For example, downsizing or moving to a lower-cost area could allow you to cut your living expenses below 50% and save more for retirement.
You can use this rule to start house shopping online, but you wonât know what you can really afford to buyâwhether more or lessâuntil you get preapproved for a mortgage by a lender.
Hereâs why: Lenders will qualify you for a mortgage based on two ratios. One is the front-end ratio, which restricts your housing expenses (mortgage principal and interest, real estate taxes, insurance, homeowners association dues, and special assessments) to 28% of your gross annual income. It also includes private mortgage insurance if your down payment is less than 20%, hazard (homeowners) insurance and flood insurance.
Say you have a household income of $120,000, no other debts, and you want to buy a home in Phoenix, Ariz. With a 4%, 30-year mortgage, a 20% down payment, a property tax rate of 0.58% (according to Attom Data Solutions) and the stateâs average annual hazard insurance bill of $1,867 (according to Insurance.com), you could afford a home worth about $613,000. But in a high-cost area, property taxes and insurance can hit hardâand lower the value of the homes you can afford. For example, in Westchester County, New York, with a property tax rate of 2.29%, an average annual insurance bill of $3,082 and all other things being equal, the price of the home you could afford would fall to about $580,000.
To make sure you can pay your mortgage, lenders use the back-end ratio to limit all monthly debt payments (mortgage, second mortgage or home-equity line of credit, student loans, and installment debt) to 36% to 50% of your gross monthly income. The amount depends on whether the loan is backed by Fannie Mae, Freddie Mac or the Federal Housing Administration (FHA), as well as your credit score, down payment and reserves. In 2017, the mortgage giants loosened up on the back-end ratio to assist first-time home buyers who have a lot of student debt. But in 2018, they began to tighten up a bit out of concern that maxed-out borrowers who lose their jobs or are hit with high medical bills will be at greater risk of default.
To get a more accurate idea of how much you can afford, use an online mortgage calculator (visit bankrate.com or hsh.com). Or call a mortgage lender, such as Quicken, to get prequalified (an estimate based on self-reported information) or preapproved (a commitment to lend a certain amount based on documented information). Youâll avoid setting your expectations too high or too low and look at houses you can afford. A preapproval will assure home sellers that you can close the deal.
The monthly mortgage payment for which you qualify doesnât reflect the total cost of homeownership. Youâll also have to pay for maintenance, repairs and replacement of components, such as the roof. To cover these costs, financial planners recommend setting aside 1% to 2% of the market value of your home annually in a high-yield online savings account.
The basic purpose of life insurance is to replace lost income if your spouse or partner passes away early. But the amount of insurance you need depends on a number of individual circumstances.
Decide what expenses or debts you would like to eliminate or goals you would like to meet with a life insurance payout. You may already have a benefit through your employer that will cover your final expensesâabout $10,000 for a funeral, burial and related costs. Do you want to relieve your survivor of the burden of a mortgage or other debt? Provide money for your childrenâs education? Leave a legacy for family or charitable beneficiaries? Replace what you would have saved for retirement? âYou wonât be accumulating money in your 401(k) if youâre dead, and that big pile of money that you thought would be available at the end of your working years for you and your spouse wonât be there,â says David Cordell, a professor of finance and managerial economics at the University of Texas in Dallas.
You should also consider how your householdâs expenses may change if youâre not there. They could rise, for example, if your family must pay for services that you formerly provided, such as lawn care, home repair, housekeeping, child care or elder care.
To more precisely calculate your needs, use a life insurance calculator, such as the one at lifehappens.org. When youâre ready to buy a policy, compare premiums at accuquote.com. Your least expensive option will be a term insurance policy, which provides a guaranteed death benefit for a specific timeâtypically 20 or 30 yearsâwith no savings or investment component.
Under this rule of thumb, you pay for a third of the cost of college from savings, pay a third from current income and financial aid, and borrow a third using a combination of parent and student loans.
Proponents of this rule say you should save a third of the sticker price, which can be daunting for many families. The average sticker price for the 2018â19 academic year at a four-year public institution, including tuition, fees, and room and board, was $21,370 for in-state students and $37,430 for out-of-state students, according to the College Board. The average tab at private colleges was $48,510.
In addition, you may have other expenses that take priority. Do you have high-interest debt? Are you making the maximum contribution to your 401(k)? Do you have an emergency savings fund? On the other hand, if youâve checked all of these boxes and still have income left over, you may want to save more than a third and reduce the amount your child will need to borrow. (And keep in mind that if your child qualifies for financial aid, the net price will be far less.)
To calculate how much you must save each month to reach your goal, use the college savings calculator at SavingforCollege.com. You can customize the result by entering your childâs age; choice of public or private, in-state or out-of-state school; what portion of the projected costs you hope to cover; and other factors.
For most parents, their stateâs 529 college-savings plan is the most effective way to save for college. Earnings will accumulate tax-free, and many states offer tax breaks for contributions.
If you have 20 years until retirement, that replacement rate is a âvery basic starting pointâ for estimating the total savings youâll need for retirement, says David Blanchett, head of retirement research for Morningstar Investment Management. However, it assumes that your spending will increase by the rate of inflation annually and that your retirement will last 30 years, neither of which is necessarily true. His research shows the actual replacement rate required to maintain your preretirement lifestyle during retirement varies significantly by household, from less than 54% to more than 87% of preretirement income.
Once youâre within striking distance of retirementâsay, three to five yearsâtake stock of your current expenses and try to anticipate what will change. Will you downsize to a less expensive home? Will you still provide some support to your children or grandchildren? How do you want to spend your time in retirement? âSome people will be happy reading a book. But for those who want a really active retirement, their income target could exceed their current income level,â says Blanchett.
On the other hand, certain expenses will disappear in retirement. Youâll probably stop contributing to your retirement accounts, and unless you continue to work, you wonât pay Social Security and Medicare taxes. Once youâve estimated what youâll spend in retirement, add up your expected sources of income from Social Security, pensions and annuities, as well as withdrawals from savings, to see if you are on track (or use our Retirement Savings Calculator).
When saving for retirement, a conventional rule of thumb is to subtract your age from 100 to determine how much to invest in stocks. But that could leave you with a portfolio thatâs too conservative, given longer life spans. If youâre 65, for example, you could live another 30 years or more. With just 35% in stocks, your portfolio may not grow enough to last that long.
Wade Pfau, professor of retirement income at the American College, in Bryn Mawr, Pa., and Michael Kitces, director of wealth management at Pinnacle Advisory Group, in Columbia, Md., have tested the guideline against others for an individual who retires during a bear market. They found that you would run out of money sooner using the old rule of thumb than if you maintained a 60%-40% split between stocks and bonds throughout retirement, with annual rebalancing.
Some proponents have revised the rule of thumb, recommending that you subtract your age from 110 to 125, depending on other sources of income and your tolerance for risk. At 125, our hypothetical 65-year-old would have 60% in stocks.