The clue is in the name. Personal finance is personal. The right answer (even if there is one) will be different for everyone. However, it’s good to have a few personal finance rules to live by to keep you on the right track.
I assume you are here because you are striving to improve your finances. Because you want to achieve your financial goals. Because you want to live the life you dreamed.
As such, I believe that the following 10 rules of thumb will be applicable for 99% of people reading this article. Let me know in the comments if I’m wrong.
By following these 10 personal finance rules to live by, together with a good understanding of your finances and a drive to succeed, your finances will significantly benefit as a result.
Rule 1: Housing Expenses
If you are renting, limiting your rent to 25% of your net income will mean that you can save up more quickly to get on the housing ladder.
When buying, by limiting your mortgage costs to 25% of your net income, it makes sure that you don’t overextend yourself financially in the house purchase.
Rule 2: Mortgages
Whilst different lenders vary, most will tend to lend you between 3.5 and 4.5 times your pre-tax income. This is equivalent to between 4 times and 6 times your net income depending on your tax band.
However, you have to remember that the banks want to lend you as much money as possible because that is how they make a profit.
Sticking to 2.5 times your income is a much more prudent figure, but may mean that you need to save up a little longer for a bigger deposit. Note: this is not a bad thing!
Rule 3: New Cars
Really? That seems strict, doesn’t it?
Well, in reality, I would say that the rule should be even stricter. Even a millionaire REALLY has to love that “new car smell” to justify buying a new car.
Remember, according to the AA, a new car loses on average 40% of its value in the first year.
So, for example, you can either buy a new car for £10,000, or a one-year old car for £6,000.
£4,000 is a lot of money to pay for that new car smell!
Rule 4: Savings Rate
And ideally your savings rate should be as high as you can possibly make it. As per the Moneystepper Savings Challenge, your “savings rate” is defined as everything you put towards savings & investments (including pensions, ISAs, capital repayment of debt) divided by your net income.
I truly believe that this should be at least 20% for every single person. The average for 2015 for Moneystepper Savings Challenge participants was 50%!
Rule 5: Investment Returns
This is a rule that is not very well known. And it isn’t very well known because I’ve just made it up!
Also you should note that the 5% should be re-analysed when the Bank of England exchange rate changes (currently 0.5%).
Take all of your overall annual returns (including capital growth on your own property, capital growth and income on investment property and shares, interest on savings, “effective savings” by paying down debt, employer pension matches and any other investment accounts).
Then, divide this amount by what your net worth was at the start of the year.
This resulting figure should be above 5%. Then, to make it “average”, you should flex returns where you have no control over the short-term variance.
This needs an example. Say I have a net worth of £100k at the start of the year and my investments (and liabilities directly related to my investments) are as follows:
- £20k invested in the FTSE 250
- £250k home
- £200k interest only mortgage (@3% int)
Let’s say over the course of the year that the FTSE 250 falls 2% and pays £1k dividends (5%). The capital growth on your property is 4% in the year in line with the national average.
Therefore, your basis returns are -£400 from FTSE capital growth, £1,000 from dividends, -£6,000 in interest on your home and £10,000 in capital growth.
Therefore, your final net base return is £4,600 vs your net worth of £100,000. This means that your based return on your net worth was 4.6%, which is below our target.
However, we don’t have any control over the FTSE 250 and housing markets, and have been hit by short term variances. Looking at prior market data from google finance and the Nationwide HPI index (63 years), we can see that the long-term averages are more like 8.5% and 7.5% for the two markets respectively.
Hence, we can turn our returns into averages by adding 10.5% onto our FTSE 250 and 3.5% onto our housing capital, giving extra returns to return to average of £2,100 and £8,750.
This gives us a final flexed average return of £15,450 and an annual return of 15.45% on our net worth. Good stuff!
Rule 6: Investment Decisions
Every single decision when it comes to your finances should be considered via an investment analysis. This means cracking out Excel and doing the maths.
Should you pay off your student loan or invest that money into your pension? You’ll find the right answer in the maths.
Should you keep 3, 6 or 12 months in an emergency fund? Again, the answer is in the maths.
Rule 7: Debt Repayment
The “snowball method” of debt repayment recommends that you pay down your smallest debt by amount first. Then, once that is paid off, you move to the next smallest debt. The argument is that the good feeling from crossing a debt off your list acts as an incentive to continue.
However, this is only an incentive if you’ve ignored rule 6. Once you understand that following the snowball method rather than the “avalanche method” (paying off debts in order of highest interest) is costing you £100s, if not £1000s, you’ll change your tune.
Rule 8: Budgeting
This is a tough one to follow, but has two hugely beneficial outcomes:
- You won’t buy anything on a whim and therefore save money on items that you only want in the short term
- It will encourage you to budget realistically
Rule 9: Shopping
You should never go shopping hungry, but more importantly you should never go shopping without a list.
This is basically a continuation of rule 8. On your single shopping trip, your list becomes your budget and you can’t buy anything that is not on it. That will stop you buying things just because they are on offer, or the fancy packaging has caught your eye!
Rule 10: Work
Again, this is probably new to you.
In rule 6, we said that you should think about every financial decision as an investment and analyse it as such.
Equally, for any “work” that you do, you should think about your hourly value.
Firstly, you need to calculate what you can earn in one hour (whether this be from overtime, side work, online income or anything else). Then, you should think about jobs, chores and tasks in terms of this amount.
For example, you might be able to earn £25 an hour working overtime and you can employ a cleaner for £8 an hour. If the cleaner can genuinely replace two hours a week that you spend cleaning, and you can work those two hours, hiring a cleaner will earn you £34 a week!
On the contrary, say you are paying £1000 a month for childcare and you earn less than that going to work, maybe it makes sense to stop work in the short term to stay at home with your children.
Always think in terms of hourly value!