Accounting For Bad Debt Expense On Cash Flow Statement 6 Financial Rules of Thumb

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6 Financial Rules of Thumb

I wonder how many of you are big readers. You know the kind who can read a book a week or search endlessly for data and advice to help them develop a financial plan that will put them on the path to prosperity.

However, if you’re like most people and don’t have the time (or desire) to read a mountain of books, magazines, and websites, then this article is for you. It will list the main “rules of thumb” for financial planning.

1. Savings/Investment Rules:

Pay yourself first: Aim to set aside at least 10% of your take-home pay

I’m sure you’ve seen this rule before. I first read it in The Richest Man in Babylon. As you’ll learn, paying yourself first is the most important bill you’ll pay each month.

The best way to enforce this rule is to automate it. Deduct 10% of your take-home pay from your paycheck and deposit it into a separate bank account. If your employer doesn’t allow you to do this, set up a transfer of ten percent of your paycheck between your main account and your “ten percent” account.

If you already have a well-funded emergency fund and your short-term goals are funded, you can put all ten percent into a retirement plan. Of course if you set aside 10% in your retirement plan, you will be contributing pre-tax more than 10% after tax.

2. Short-Term Loan Rule of Thumb:

So-called “bad” debt should not exceed 20% of your income

Short-term debt includes your car and student loans, as well as your credit cards and other types of debt. Basically everything except your mortgage. You need to list all your outstanding payments and their corresponding minimum/monthly payments. Now add the minimum/monthly payment amount and you come up with a figure.

Take this number and divide it by your monthly take-home pay.

If the result is more than 20%, you are borrowing too much. New entrants to the workforce or recent graduates with student loans and low-paying entry-level jobs often have high debt-to-income ratios.

Compulsive spenders also have problems because they spend every dollar.

You should aim to put at least 20% of your net salary towards paying off your outstanding debt. If you stop adding to your short-term debt today, you’ll find that you can pay off most of your short-term debt in anywhere from 3-7 years.

3. Rule of Housing Cost:

You should spend less than 36% of your monthly salary on housing

This rule is mostly for homeowners, but if you rent and spend more than 36% of your monthly salary on rent, you either live in NYC or San Francisco and it’s time to find a new place. Either that or find another roommate.

Why 36%?

Well, banks like to see that your monthly mortgage payment, taxes, insurance and utilities costs won’t put an undue burden on your finances.

In short, they calculate your cost of living and know that if you’re paying more than 36% for your housing costs, you’ve probably bitten off more than you can bite off.

Whatever your current percentage is, aim to lower this percentage over time. Banks are ready to lend you up to 28 percent of your gross monthly income, but that doesn’t mean you should borrow that much money to buy a home.

The less money you borrow, the sooner you can pay it back and the higher your monthly cash flow (because you’re spending less on your mortgage). The less you spend monthly, the more you have to invest in your future.

4. Rule of Thumb for Retirement:

You need to save about 20 times your annual gross income to retire

There are a whole bunch of calculators and spreadsheets on the internet (I have one too) that you can use to figure out how much you’ll need to pay for retirement. I’ve never met anyone who has the patience to fill one of these out and it only takes a couple of minutes to complete! The solution is what author Robert Sheard calls the Twenty Factor Model.

Essentially the formula is:

Financial Freedom = Annual Income Requirement X 20

This formula is based on two centuries of stock market returns and the real rate of return (5% p.a.) you could get after taxes, expenses and inflation.

If you have 20 times your annual income requirement, which means a 5% annual withdrawal rate from your nest egg and a 5% annual expected net return on your investments, you’ll never run out of money.

Now isn’t it easier to multiply your gross income by 20 than to fill out one of those online calculators? I thought so. Let’s move on.

5. Insurance rule of thumb:

Your policy should be at least five to eight times your annual income.

Some planners suggest that you stick to five to eight times your annual income depending on the level of coverage. My suggestion is that you get your financial house in order, i.e. get your net worth and cash flow statements together and talk to a good insurance agent about your needs.

He or she will be able to walk you through the various options. As with a financial planner, ask how they are compensated to be honest with the advice they give you.

Please note that this factor or rule can be very high, depending on the number of years of income you need to change. The highest “factor” I’ve seen is multiplying your annual after-tax income by 20.

Interestingly, it is similar to the rule of thumb above. No coincidence here. If you die and want to make sure your dependents keep getting exactly what you bring home each month, they need to completely replace your income forever. According to the Twenty Factor Model, an insurance policy worth at least 20 times your annual income would be worth it.

6. Charity Rule of Thumb:

Pay at least 10% of your net salary every month.

Most of us feel that there is not enough money to go around. We live in a state of scarcity instead of abundance. We think that if we give away ten percent of our income every year, we can’t possibly make ends meet or have a decent retirement.

I understand the fear, but if you follow the previous five rules, you won’t have to worry until the end. Explain to me.

Journalist Scott Burns, in an article titled “A Look at Returns,” analyzes how much money you need to save to avoid running out of money by the time you die, assuming you retire at age 65. It concluded that we would need to save 34 percent of our income if we planned to live another 20 years after retirement. The analysis assumed that we would not be able to earn a return on our investment.

But you get something for your investment, right? Of course you will. Burns points out that the higher the return on investment, the less you need to save.

The 34 percent of income young people have to save today if they earn no return drops to 25 percent if they earn bonds’ historic 2 percent real return.

If they earn the 5 percent real return that a 60/40 stock/bond portfolio would earn, that drops to 15 percent.

A real return of 7 percent on common stocks drops to 9 percent of income.

You are already setting aside 10% of your money (Pay Yourself First Rule of Thum) and once you pay off your short-term debt, you will be freed up to invest the extra 20% of your salary wisely. Actually, if you’re putting money aside tax-deferred, you’re putting aside more than 10% of your net pay each pay period, but why split the case?

In short, you have more than you think.

Give a little away and see how little it affects your lifestyle. Of course you will feel good about yourself and you will help others in the process. No wonder this is my favorite rule.

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