You may have heard of the rule of 72 or the 50/30/20 budgeting rule. These are some of the simple rules of thumb that can potentially help you. We look at six common financial principles – how they work, why they work, and when to know if a rule of thumb isn’t right for your situation.
1. The rule of 72
The rule of 72 shows how long it takes for investments to double in value. Just divide 72 by the annual return your money earns, and the result is the number of years it will take to double your money.
For instance, if you invest $20,000 for an annual return of 5%, it’s going to take almost 14.5 years to grow your capital to $40,000.
Why it works
The rule of 72 is based on a complex equation for compounding returns. Trivia buffs may be interested to know that using 69.3 gives a more accurate figure than 72. But 72 was chosen as it was believed to be easier for mental arithmetic back in the days when we didn’t all have a smartphone calculator.
The biggest drawback of the rule of 72 is that investments rarely earn the same return each year. In fact, when it comes to shares, returns can fluctuate wildly from one year to another. That’s why the rule of 72 is a general guide only.
2. The rule of 25 for retirement
Not sure how much money you need for a comfortable retirement? The rule of 25 may help. First, decide how much income you need for your preferred retirement lifestyle. Let’s say $50,000 annually. Then, multiply that figure by 25. The result is the nest egg needed to achieve that income – in this case, $1.25 million.
Why it works
The rule of 25 was devised in the 1990s by US financial planner William Bengen, who crunched the numbers to show that a retiree who draws down 4% of their savings each year won’t face the risk of outliving their savings.
The rule of 25 has a couple of weak spots. To begin with, it assumes all your retirement income comes from private savings. Yet close to one in two Australian retirees receive at least a partial age pension, according to data by the Australian Bureau of Statistics (ABS). In addition, the rule was based on a very conservative portfolio of investments at a time when interest rates were vastly higher than they are today.
There are practical hurdles too. Retirees who invest their super in an allocated pension have to comply with minimum annual drawdowns set by the Federal Government. These limits have been halved until 1 July, 2022, but normally, a minimum drawdown of 5% of capital applies from age 65, steadily increasing with age.
3. Hold six months’ worth of expenses in your emergency fund
It always makes sense to have rainy day savings, and while the commonly held benchmark used to be the equivalent of three months of living expenses, this is creeping up thanks to the pandemic.
Why it works
Having savings – no matter whether it’s equal to three or six months’ worth of expenses – isn’t just a financial safety net, it can also be a huge stress reliever. Canstar’s 2020 Consumer Pulse report found 21% of people live pay to pay. That can mean living on a knife-edge of uncertainty in case something happens to your job, or if an unexpected bill crops up.
Saving six months’ worth of living costs is a solid target. Households spend an average of about $74,000 annually on general expenses. Meeting the six-month benchmark would mean accumulating $37,000. This is more than double the current median savings which, according to the Canstar Consumer Pulse Report, is $15,000.
Rainy day savings should focus on the essentials like rent or mortgage payments, utilities and groceries. The best way to know how much you need in emergency savings is to take a look at your budget. Remember, if you can’t work due to illness or injury, then you may have income protection insurance to help you through a tight spot.
4. The 50/30/20 budgeting rule
The 50/30/20 rule provides a simple way to divide your pay cheque. Half your (after-tax) income goes to living costs, 30% goes to wants (discretionary spending) and the remaining 20% goes towards saving and investing.
Why it works
In our busy lives, simplicity holds plenty of appeal. The 50/30/20 rule is a basic guideline for divvying up take-home pay across various ‘buckets’.
The biggest downside of this rule is that it doesn’t reflect individual circumstances. If you’re saving for a first home, you may want to put a lot more than 20% of each pay packet into savings. Or, if you’re a low-income earner, the idea of spending almost one-third of your income on new clothes or fine dining may seem like wishful thinking.
The key is to mix and match the proportions to find what works for you. If 60/20/20 or 50/20/30 is better suited to your goals, go for it.
5. Spend less than 30% of your income on mortgage repayments or rent
This long-standing rule of thumb is great in theory, but is it possible to stay below the 30% benchmark when property prices are rising rapidly? To find out, let’s look at some numbers.
ABS data shows average weekly full-time earnings are currently $1,770, or $7,611 each month (bearing in mind there are 4.3 weeks in a month) and that the average new loan is worth $505,000.
At the average interest rate of 2.77%, monthly repayments would be $2,335 assuming a 25-year term. That works out to 30.6% of monthly income – pretty much bang on the 30% benchmark.
However, a large number of lenders are offering 30-year terms. A home buyer who takes this option would see monthly repayments fall to $2,067, or 27% of monthly pay.
For the record, most tenants are easily meeting the 30% rule. The Domain Rental Report for March 2021 showed that nationally, the average weekly rent is $471, or 27% of earnings.
Why it works
As the Reserve Bank has noted, the 30% threshold is often used as a rough indicator of the limit for sustainable home loan repayments. But it’s not set in cement. As anyone who’s ever applied for a mortgage will know, lenders look at a whole range of factors including living expenses, other debts and your personal credit history, to decide how much you can borrow.
That said, aiming to follow the 30% rule means you still have money to enjoy life, without being stretched to the point where an unexpected bill could derail your finances.
The 30% rule is based on the loan rate you’re paying now. That’s fine in today’s market when interest rates are at record lows. But they won’t stay that way forever. It makes sense to take a leaf out of the banks’ book and stress test your finances to see how you’d manage home loan repayments if rates climbed higher. Rising rates could push you over the 30% line.
6. The rule of 110
The rule of 110 (or 100 or 120) is a guideline for how much of your portfolio should be invested in shares at any given age. Subtract your age from 110, and the end figure is the percentage of shares you should hold.
As a guide, if you’re aged 30, 80% of your portfolio should be in shares. If you’re 50, 60% should be in equities, and if you’re aged 70, the rule states 40% of your wealth should be in shares.
Why it works
The rule of 110 rests on the notion that the younger we are, the more risk we can afford to take. After all, a 30-something has far more time to wait for sharemarkets to recover from a fall than an 80-year old.
Risk tolerance is a very personal thing. If the idea of having a massive chunk of your money tied up in shares is going to keep you awake at night, this rule isn’t for you. Bear in mind too, most Australians already have significant indirect exposure to the sharemarket through their super.
The upshot is that financial rules of thumb provide handy guidelines, but they are not like the laws of physics. They can be bent and fine-tuned to suit you, your circumstances, and your goals.
Cover image source: ullrich/Shutterstock.com
About Nicola Field
Nicola Field is a personal finance writer with nearly two decades of industry experience. A former chartered accountant with a Master of Education degree, Nicola has contributed to several popular magazines including the Australian Women’s Weekly, Money and Real Living. She has authored several best-selling family-focused finance books including Baby or Bust (Wiley) and Investing in Your Child’s Future (Wiley).
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