financial rules of thumbFor many Americans, getting a handle on complex financial topics can sometimes feel like trying to understand another language.  In response to this, financial pundits created “rules of thumb” with the goal of simplifying what could otherwise be unnecessarily complicated financial choices.  From how much home you can afford and the size of your cash reserve to how much you can withdraw from your retirement account, financial rules of thumb can be a helpful starting point in the discussion.  However, it is important to understand the relevance of these rules to your unique financial situation.

How much you can withdraw from your retirement account?

“How much can I afford to spend?” is one of the biggest questions many retirees have when planning for “life after work”.  While there are many factors to consider when answering this question (various income sources, rates of return, inflation, etc.), determining how much you can withdraw from your portfolio has become one of the most hotly debated topics in personal finance.  Retired financial planner William Bengen’s 1999 study in the Journal of Financial Planning was the first to document the merits of the “4% Rule”.  This rule stated that a 4 percent withdrawal (plus increases for future inflation), was the maximum amount that could be withdrawn from a portfolio without depleting assets pre-maturely.  So how did the results look?  During the 30-year withdrawal periods used in the study, 4 percent appeared to be the highest withdrawal amount possible.  While this may serve a starting point in the withdrawal conversation, there are some limitations to this rule that all investors should consider.

The issue: First, past performance gives no indication as to what future returns and subsequently, withdrawal success will be.  For example, how does the current low interest rate environment impact “safe withdrawal rates”?  Wade Pfau, a professor of Retirement Income at The American College highlighted concerns regarding lower yields and the impact of inflation on real rates of return.  These concerns have led Wade and others to suggest an initial withdrawal rate of closer to 3 percent.  Rather than a “set it and forget it” approach, other research has supported the notion of systematically re-visiting your analysis and adjusting withdrawals according to market valuations and even performance.  Bottom line – Since there are many individual factors to consider and no withdrawal rate can guarantee you will not deplete your assets prematurely, be sure to consider your entire financial plan before entering the distribution phase of retirement.

How much home can you afford

Like retirement withdrawal rates, there are many different rules of thumb for how much house you can afford.  Much of the confusion stems from how much banks will loan versus how much you can manage to pay for.  The fact is, these are two totally different numbers.  Typically, banks will examine debt-to-equity ratios along with other factors as part of their underwriting approval process.  However, because a bank will lend you the money, doesn’t mean that you can afford to pay back the loan.  As a result, other rules of thumb have been developed including the 2.5X rule.  The rule is fairly simple, take your total gross income and multiply it by 2.5 to determine the maximum price you should consider spending on a home.

The issue: There are a couple of important issues to review.  First, interest rates have a huge impact on payments and subsequently how much home you can afford.  With 15 and 30-year mortgage rates at 3.18 and 3.93 percent respectively (Freddie Mac Primary Mortgage Market Survey), principal and interest payments are more affordable at these levels.  Alternatively, higher interest rates will reduce affordability.  In addition to the impact of higher interest rates, other debt such as student loans, credit cards and automobile loans impact what you can afford.  Bottom line – there is no substitute for a budget that takes into consideration income, taxes, liability payments and living expenses when determining the right price-point for your home.

The size of your emergency fund

When it comes to planning for financial curve balls, financial experts have created multiple rules of thumb for how much of a reserve you may need.  From using a multiple of monthly expenses to relying a home equity line of credit (HELOC), there are many different approaches to establishing an emergency fund.  The more widely accepted 3-6 months of monthly expenses seems to get the most traction in the financial media.  The idea here is that if you lose your job or experience any significant unexpected expenses, you have at least 3-6 months to re-group and get yourself back on track.

The issue:  Greater degrees of financial uncertainty may require larger cash reserves.  For example, does your family rely on one source of income?  Is there more uncertainty in your field or industry? (ie, retailing) Do you have children or parents that you may have to step in and support?  Is your home overdue for major renovations (roof, appliances, etc.) or are you getting ready to send your children to college?  The liquidity and aggressiveness of other investments should also be considered.  For some savers, traditional rules of thumb should be modified to include larger cash reserves.  This may be especially important for those beginning to transition into retirement.

While financial rules of thumb are worth reviewing, they are merely a starting point.  There is simply no cookie cutter approach to pursuing your financial goals and investors should consider their unique circumstances before implementing any strategy.  Also consider working with your financial and tax adviser to determine the most appropriate approach for you.