Financial Rules of Thumb Explained for Dummies

What is a rule of thumb? 

  A rule of thumb, called a mental shortcut, refers to a general principle that helps a person to make a decision or to take a certain course of action.  Put differently, a rule of thumb is an informal and simple guideline, making problems and challenges easier to understand.     Typically, rules of thumb are based on practical experience rather than scientific research or theories. Furthermore, they are not a guarantee that the outcome will be exactly as described in a rule of thumb.    

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Comprehending rules of thumb 

  Generally, rules of thumb cover a wide range of subjects that may be relevant to numerous people. However, they may not be suitable for every individual or a specific situation.   Financial rules of thumb may be helpful for people who are just starting their financial planning. They can also assist a person in putting a proper financial plan and budget in place.     Bear in mind, rules of thumb only provide a general direction and may not present the exact picture.  Rules of thumb should be considered objectively, and when a rule is applied, its object as well as its limits should be contemplated.     

Examples of financial rules of thumb 

  Financial rules of thumb cover a wide range of subjects, including methods and procedures regarding retirement planning, investments, acquiring a home, budgets, a personal emergency fund, and savings, to name a few.     There are numerous financial rules of thumb. Some are well-known, such as the 50/30/20 rule of thumb for budgeting, and the Rule of 72 regarding an investment.    The following nine financial rules of thumb will be explained as examples of this category of rules of thumb:    The 50/30/20 rule   The 50/30/20 rule of thumb provides three easy guidelines to assist you in planning your budget. Your monthly net income - a person’s income from a salary or wages after deductions, such as tax and UIF - is allocated to the following three categories:   

• 50% to needs 

A need is something essential without which you cannot live. For example, food, water, and a place to stay.   

• 30% to wants 

Wants refer to things you desire but do not necessarily need in order to live. They may include things such as:   

1. Holidays 
2. Dining out 
3. Hobbies 
4. Streaming services like Showmax and Netflix 
5. Digital Satellite Television (DStv) (in Sub-Saharan Africa) 

 

• 20% to financial goals 

This category consists of two main sections: 

1. All savings for short, medium, and long-term goals like retirement contributions, savings for a home, and provision for the education of children, to name a few.  
2. Debt payments. 

The 50/30/20 guideline was made popular by a US senator, Elizabeth Warren, and her daughter, Amelia Warren Tyagi, in the book All Your Worth: The Ultimate Lifetime Money Plan.  Percentages for the three categories may need adjustments, based on a person’s personal circumstances.  Although it helps you to plan your budget, it does not actually keep track of your budget.    The 20/4/10 rule   The 20/4/10 rule of thumb is useful when you want to buy a vehicle that will fit your personal budget. In accordance with the formula, you should make a down payment of 20% on a vehicle loan with a repayment period of four years and keep vehicle expenses below 10% of your monthly income.     Vehicle expenses consist of loan repayments, maintenance, fuel, and vehicle insurance.  You can use your gross or net income to determine the 10 percent amount. If you use your gross income, you will be able to spend more on your vehicle. However, using your net income will provide a more conservative and manageable amount.     For example, a person with a monthly net income of R50 000 should aim to spend less than an average of R5 000 (R50 000 x 10%) per month on vehicle expenses.     Rule of 72   The Rule of 72 is used to calculate how long it will take for an investment to double in value, based on the annual rate of return it can generate. The rule applies to cases of compound interest, not simple interest. Also, the calculation is based on a single average rate of return over the life of the investment and is reasonably accurate for interest rates between 6 percent and 10 percent.    The formula to calculate the period of time an investment will double is as follows: Divide the integer 72 by the expected annual rate of return. For example, at a nine percent rate of return, the investment can double in value in eight years (72/9 = 8).   The Rule of 72 can also be used to determine the annual rate of compounded return from an investment, given the number of years it will take to double the investment. This calculation is done by dividing the integer 72 by the number of years needed to double the investment. For instance, if the value of the investment is doubled in 6 years, the annual rate of compounded return will be 12 percent (72/6 = 12).    The 20/10 rule    The 20/10 rule of thumb enables a person to ensure that his/her consumer debt payments do not exceed 20% of his/her annual net income (also referred to as take-home income) and 10% of his/her monthly net income.     This rule allows you to determine whether you borrow too much, protecting you against financial strain. Put differently, it helps you to keep your finances under control.  In the calculations, only consumer debt - debt incurred by a person mainly for personal, family, or household purposes - is included, while mortgage debt is excluded.    For example: 

• Susan earns a net income of R15 000 per month. According to the 20/10 guideline, she should not pay more than R1 500 per month on consumer debt payments. 
• Furthermore, Susan should limit her annual consumer debt payments to less than 20 percent of her annual net income. To adhere to this guideline, Susan needs to make the following calculation:  

1. Annual net income = R15 000 (monthly income) x 12 months = R180 000 
2. Total of outstanding consumer debt should not exceed 20% of annual net income = R180 000 x 20% = R36 000 

A major disadvantage of the 20/10 rule of thumb is that it can be difficult for people with student loans to adhere to the guideline.    The six-month emergency fund rule    An emergency is usually unforeseen, unexpected, and unplanned and can happen anytime. Examples are retrenchment and medical expenses.  The guideline is that you should have an emergency fund that amounts to six months’ worth of household and personal expenses.    It is a rule of thumb that can provide great comfort and big support when an emergency arises, helping you to avoid desperate and hasty decisions that can weaken your financial position.  However, depending on the nature of the emergency, even six months’ savings may not be enough.    Savings for retirement    A well-known rule about retirement is saving at least 10 to 15 percent of your net income (take-home income) for retirement.  It provides people with a simple figure to work with. However, the percentage does not consider the following two factors, namely: 

1. how much a person has already saved for retirement, and 
2. how much money a person needs in retirement.  

  Homeownership    Two rules of thumb can be applied to own a home eventually. 

1. The price of a home should be less than an amount equal to two and a half years of a person’s annual income. 
2. A prospective homeowner should pay a deposit of at least twenty percent of the home price. Although 20% can be unrealistic as it is a huge amount to save. 

  Life insurance   One should have a life insurance death benefit which equals at least five to ten times one's annual gross salary. The actual amount required may depend on financial goals set, dependents, your age, and other requirements.    Credit cards   One should pay off the highest-interest credit cards first.   

You do not need a bag of salt 

  You do not need a bag of salt when considering financial rules of thumb - only a pinch or grain of salt, meaning that you are not required to agree to a rule of thumb completely. You can have reservations about its effectiveness in your circumstances.   They are only guidelines that can guide you in your financial decisions, not laws which cannot be altered.    Note: This article does not constitute investment, financial or trading advice. Please obtain the advice of a professional, reputable, and regulated broker before making trading and investment decisions.  

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