So many rules. Fortunately, these rules, as Dr. Peter Kim tells us, are not set in stone or enforceable by law.
These are the kinds of rules that you will want to follow. That is, assuming you’d like to grow your wealth and achieve financial freedom.
You don’t have to abide by each and every one, but these guidelines are designed to help you make better financial decisions, and the math is generally quite simple. Peruse the list and see which rules of thumb you’re following, and which rules you’ll willingly bend or break.
This post originally appeared on Passive Income MD.
It goes without saying that finances can be tricky. It doesn’t matter if we’re talking about buying a rental property, investing in a crowdfunding deal, or even just making a budget -it’s easy to get caught up in all the minutiae. I’ll frequently find myself in such a position, wanting to act on something but getting stuck in a classic “paralysis by analysis” situation.
In times like this, what has helped me greatly is to refer to some simple rules of thumb for each situation. If you’re considering an investment or a purchase, having a rule of thumb can give you have a quick idea whether it’s worth your time to pursue or analyze it further. Think of these rules of thumb as a basic guide to help make a quick determination.
Thinking more big-picture, rules of thumb can also come in handy (so to speak) if you’re looking to assess your own situation – especially if you’re wondering whether you’re on track with your current financial goals. Having an easily-gauged rule of thumb will tell you if you’re at least in the ballpark or on the right trajectory.
Of course, it’s important to recognize that these do not apply to everyone and every situation. But hopefully, these rules can put things in a broad perspective.
Here is my list of favorite financial rules of thumb:
Buy vs. Rent (Price-to-Rent Ratio)
The price-to-rent ratio is often used to help make the decision of whether it’s better to rent or buy. You simply divide the rent you would pay in a comparable place into the sale price to get this ratio.
For example, you find a home that costs $250,000, and the home is renting for $1,800 per month, which equals $21,600 per year in rent ($1800 x 12). $250,000 divided by $21,600 equals 11.57 which is your price-to-rent ratio.
Greater than 20: Better to rent than buy
Less than 15: Better to buy than rent
Between 15-20: Gray area that requires taking into account other factors such as how well the overall housing market is doing or how quickly rent prices are increasing.
This rule of thumb is also a good way to compare affordability of buying or renting from city to city.
Buying a Home – How Much House Can You Afford?
You’ll hear the rule of thumb being anywhere from 2.5 times to 4 times your annual salary. In his course, the White Coat Investor likes to say it should be 2.5x – 3x your salary.
This rule of thumb is good because it keeps you from overstretching and putting yourself in a house-poor situation. The lenders have their own set of exact qualifications but it helps to start with your estimate when you’re looking around. Also, just because a lender tells you that you can “afford” to take out a certain size mortgage, it doesn’t mean you necessarily should go to the maximum.
Unfortunately, this rule of thumb can be tough to follow in some high cost of living areas.
1% or 2% Rule for Buying Rental Property
This rule states that your investment property should rent for 1% of the purchase price.
For example, if you purchase a 5-unit apartment building for $800,000, it should bring in $8,000 a month in rent ($8,000 is 1% of $800,000). This will likely help to ensure that you are in a cash flow positive or at least cash flow neutral situation. Some people use 2% as the rule, but unfortunately that isn’t a mathematical possibility in most parts of the country. Again this depends on location and risk tolerance.
50% Expense Rule
This rule states that expenses for a rental property apart from the mortgage will likely average to about 50% of the rent.It helps you to quickly estimate monthly cash flow.
For example, for this property mentioned above that brings in $8,000 a month, assume $4,000 will go towards management, maintenance, vacancies and all other expenses. If you have $4,000 left and the monthly mortgage is $3,000, then you have $1,000 left as cash flow per month.
Again, whether this rule over or underestimates expenses depends on a good number of factors:
- Does your building require a significant amount of maintenance – is it new vs 50 years old?
- Do you have a property manager or do you self-manage?
- Do you have a high turnover rate depending on your unit mix or is it a single family home and have the renters on a 2-year lease?
The 70% Rule
This is a rule mainly for people trying to fix and flip. It states that the purchase price of the property plus the rehab should be at most 70% of the ARV or After Repair Value (the market price you can sell it for).
The way people use this rule is that they find a property, figure out what they could sell it (using neighborhood comps) for after they rehab it(using neighborhood comps), multiply it by .7, subtract out the cost of repairs and voila, there’s your max purchase price.
For example, you’re looking at purchasing a property and think it could sell for $500,000 all fixed up, and you assume it would take $50,000 worth of rehab to get there. Well take $500,000 x .7, then subtract $50,000 and that leaves you with a max purchase price of $300,000.
This rule attempts to cook in a nice profit for you while at the same time tries to give you a margin of safety when fixing and flipping. This is especially important because of market fluctuations and also because of other costs involved in the transaction.
You’ll see this % of ARV mentioned quite a bit on crowdfunding deals that you’re considering funding. You might see the number at 75% which is sometimes the rule of thumb as well, but when it starts creeping past 80% realize that the margin starts to become quite small.
Personal Finances & Retirement
Budgeting – 50/30/20 Rule
This is a simple rule to help you decide how to budget appropriately so you can ultimately make sure you’re spending your money in a balanced manner to live life today but also save for the future. It helps you decide how to allocate your spending.
50% of spending goes towards basic expenses & necessities – housing and bills
30% of spending towards dining &entertainment
20% goes towards saving towards retirement and paying down debt
Saving For Retirement – 10% or 20% of income
Again, the White Coat Investor says that saving 20% of your take-home income should be the mark for physicians and that will set you up nicely. Helps to make sure you’re paying yourself first and putting a good amount of money away for the future. They say the average American saves less than 5% and unfortunately that will put them nowhere near the target when they’re ready to retire. Don’t be that person.
Emergency Fund – 3-6 Months
Again, you’ll hear different rules for how big your emergency funds, but most likely you’ll hear that it should be between 3-6 months of your monthly expenses stored away in a very liquid, accessible place. Usually it’s in a savings account. The amount you have should depend on whether you have income coming in when you’re not working (passive income sources, delayed billing, a partner who works, disability insurance, etc.).
Stock Portfolio Asset Allocation
This rule of thumb helps you assess how much of your portfolio should be in stocks vs how much in bonds. Traditionally they say as you age, bonds should make up a larger part of your portfolio to smooth out risk as you approach retirement age.
The rule is that 120 – Your Age is the percentage you should be invested in stocks. The rest in bonds.
For example, if you’re 40 years old then 80% (120 – 40) should be in stocks and therefore 20% in bonds. At age 60, 60% (120 – 60) should be in stocks and 40% in bonds.
The 4% Rule
The 4% rule states that you can withdraw 4% of your savings each year and depending on your allocation, but it should last 30 years with over 95% certainty.
However, based on something called sequence of returns, you may decide to pull out less (like 3%) if there is a market downturn in the early part of your retirement. In short, this means that you may want to draw less early in your retirement if the stock market happens to not be doing so well otherwise you may run out of funds earlier than expected.
25x Expenses to Financial Independence.
This rule estimates how much you’ll need to retire or consider yourself financially independent. It’s using the 4% rule to see if you have enough. If you multiply your annual expenses by 25, then that’s what you need. If you have that amount, drawing out 4% a year will cover your expenses. Some choose to be more conservative and push for 30x expenses, which happens to be where the Physician on Fire at least sits at.
Both this rule and the previous one, however, don’t really take into account other sources of income like rental income, pensions, social security, inheritance, etc.
What Should Your Net Worth Be?
Do you ever wonder whether your net worth is where it should be?
Well, the basic rule of thumb of thumb for an answer this is to divide your age by 10 and multiply by your gross annual income.
So if you’re a physician and you’re 40 and make $200,000 a year, your net worth should be 800,000 at this time. (40/10 x 200,000). Obviously as physicians, we typically hit a positive net worth a little later in our lives due to additional schooling, residency, and that little something called student loans. So it’s not super applicable when you’re younger but by the time you’re 40 it probably starts to make a little more sense.
How do you know your net worth? Write it all out on a spreadsheet or use Personal Capital like I do.
Have you wondered how much life insurance you need?
Here are two simple rules of thumb:
1) Income x 10
2) Income x 10 + $100,000 for each child for higher education expenses
Pick whichever one but this attempts sure you have a nice cushion for whoever you leave behind to cover the cost of housing, education and standard living expenses for quite some time.
Again, the true amount may be highly variable dependent on the area you live in, whether your partner works, whether you have children, whether you have multiples sources of income, etc.
How Much Does It Cost to Raise Children
Have you ever heard the phrase, “I can’t afford to have any more children” or maybe you’ve uttered those same words yourself. Children are no doubt expensive, but if you feel like I do, they’re worth it (at times haha). For real, we feel blessed to have two healthy children and we’d do anything to make sure they’re taken care of.
However there is a rule of thumb to just how expensive is it to raising children. According to the department of agriculture, the estimated cost of raising a child from birth through age 17 is $233,610 – or as much as almost $14,000 annually. That’s the average for a middle-income couple with two children.
Again, this is the average. All you parents who are sending their kids to private school are likely laughing at this amount. However, it’s a good rule of thumb.
Any other rules of thumb we should add to this growing list?