rules of thumb

(In case you’re confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this on-going series is all about Financial Rules of Thumb.)

Try as we might, there are times when debts just overtake us.  Quite often it is one of several things that causes this to happen – either we’ve had unexpected expenses hit us “alla sudden-like”, or perhaps a layoff or lean time with income.  Or maybe we just didn’t pay attention and debt grew out of control.

How’d I Get Here?

The reason we’re in this position is important, because we can’t let the debts continue to increase – so the first order of business in reducing your debts is to stop the bleeding.  Figure out what the cause of the debt was, and work out a way to stop increasing the debt (if possible).  If it’s just regular spending, shopping and the like, you need to get a handle on your outflows, or come up  with a way to increase your income so that you’re not adding to the debt load.  Whatever the cause of the debt in the first place, you need to stop it from increasing.

After you’ve stopped your debt from increasing, it’s time to come up with a plan to start reducing the debt load.  In order to do this, we go back to the time-honored method of Organization, Efficiency, and Discipline to work through the debt reduction.

Organization

To start off with, you need to Organize.  List all of your debts, including the balance, interest rate and minimum payment for each.  You can do this on a sheet of tablet paper, or on a spreadsheet like Excel or Google docs.  By doing this, you can tally up your total amount that you owe, as well as how much your monthly cost is at a minimum.

For many folks this is the first time they’ve put it all together in one place, and it can be a bit scary.  What’s important is that now you know where you are… and of course, where you’re going is to take that balance down to zero.  It becomes a matter of filling in the space in between.

One way to do this is to just make the minimum payments every month, and eventually you’d pay it all off.  But there are better ways to go about this, more efficient ways, if you have a little extra to pay each month above the minimum.

Efficiency

Let’s use an example – say you have three debts, totaling $200 each, at rates of 10%, 15%, and 20% respectively.  These three debts each have a monthly minimum payment of $10 each.  If you paid the minimum on each debt every month, you’d pay off the 10% debt in 24 months, the 15% debt in 26 months, and the 20% debt in 27 months.  But let’s say you have a total of $40 to apply toward debt each month…

If you split the $40 evenly between the debts, now your 10% and 15% debts would be paid off in 19 months and the 20% debt in 20 months.  Pretty good deal, right?  You’ve shaved 8 months off the time to pay it all off.  But there’s a better way to do this.

What if you took the extra $10 and paid it toward the highest rate first?  Now the 20% loan would be paid off in 14 months.  Then, if you took the $20 that you’d been paying toward the 20% debt and added that to the $10 minimum that you’d been paying on the 15% debt (total payment now is $30), that debt would be eliminated by the 17th month.  Adding that $30 to your 10% debt payment, you’d be finished paying off that debt by the 18th month.

Not only have you shortened the timeline by a month, but by paying the highest rate debt first, you’d reduce the overall cost of the debt.  This method is known as a “debt snowball”.

Discipline

The debt snowball will only work if you stick to it… and the whole idea of debt reduction requires discipline in order to make it work.  If you start off on the project and free up some of your credit line, only to build up the debt again, you’ll be back to square one before you know it.  This is why I mentioned at the start that you need to understand how you got into this debt position in the first place.  If you’re simply spending far more money than you can bring in with your income, you have to figure out a way to fix that situation.  There is no way to resolve this problem without either bringing in more money or reducing your expenditures.

Photo by Photos8.com

(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, this on-going series is all about financial Rules of Thumb.)

Buying a car is such a common activity that many folks don’t give much effort to following any “rules” around this purchase.  I’ve often suggested a couple of rules that you may find useful or interesting…

The Decision to purchase a car in the first place

You need to be certain that your decision to purchase is based on a real need.  Too often we get caught up in our desires and “keeping up with the Jones’s” when it comes to auto purchases.  If your current car is providing you with service and isn’t beginning to fall apart, you should consider delaying a purchase until it actually makes sense for you.

The reason I say this is because a car is a depreciating asset – except in certain cases where you use your car to make money, such as in a delivery business, a car only costs you money – it doesn’t make money for you.  And the cost of the car itself isn’t the only cost you’ll incur, you also need to consider additional insurance costs… if you buy a new car, you’ll need to carry full coverage for the replacement of a much more expensive item than your current, depreciated value, vehicle.

But here’s a rule of thumb that you might use to determine the overall cost of owning a vehicle – to get an idea of the total cost of ownership, including insurance, maintenance, and all, double the price and divide by 60.  This is a rough guess of the cost, but you can probably do much better by going to a website like Edmunds.com and using their “Cost to Own” calculator.

Suggestions if you’re buying a new car

If you’ve chosen to purchase a new car, here are a few suggestions that will make your choice a better option for you in the long run:

Buy with cash.  You should save up and purchase your auto with cash if you can do it.  This way you are doing two things for yourself – 1) you’re able to negotiate specifically on the price of the new car and your trade-in’s value; and 2) you aren’t paying someone else for the use of the money.

There are exceptions to this rule, of course.  The first is if you don’t have the cash available… which means one of two things, either you will need to delay the purchase or borrow the money to buy.  Delaying is a good choice if your present auto still meets your needs (see my comment above regarding the decision to purchase a car in the first place).

Don’t finance for more than four years.  In today’s world it’s possible to finance a car for up to 72 months, or six years – but if that’s the only way you can afford to make payments, you’re taking on more than you can really afford.  This is because of the fact that a vehicle reduces in value dramatically over the first two or three years, and if you finance for much longer than three years, by the time you’ve reached the point where the car is starting to cost a lot of maintenance money (and therefore you’re thinking of trading for a newer model), it is worth much less than you still owe.  This is known as being “upside-down” with regard to the financial value of the vehicle.

Put at least 20% down.  This rule of thumb is helpful to ensure that you aren’t financing more than necessary.  This will also help you to follow the four-year rule above, all the while keeping your payments lower.  Just the same as in the “buy with cash” recommendation, if you can’t put at least 20% down in payment at the purchase, you should delay your purchase until you can do so.

Buy a used car

Another, possibly the best, rule of thumb with regard to auto purchases is to buy a used car, and drive it until it literally drops from exhaustion.  It may not be glamorous (what sound financial advice is?) but this is one of those recommendations that has passed the test of time, and has been a part of some of the world’s greatest financial success stories.

According to Stanley and Danko’s seminal book “The Millionaire Next Door”, in the chapter called “You Aren’t What You Drive” – the average millionaire doesn’t put much value on having a brand-spanking new car.  In fact, more than 37% of the millionaires that were surveyed purchased a used car most recently, and even if they bought it new, they held onto their car for a good while before trading:

Those purchasing motor vehicles accounted for 81% of the sample of millionaires; those leasing accounted for 19%.

Photo by houdoken

(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. Therefore, we’re talking about Rules of Thumb.)

In this installment of our ongoing Principles of Pollex series, we’re going to talk about two Rules from the financial world that are actually real, true, undisputed Rules, rather than the guidelines we’ve talked about before.  These two Rules are not open to interpretation.  The first is about investments, and the second is about loans.  Both are useful in their own ways…

Rule of 72

The Rule of 72 is a quick and easy way to determine when an invested amount will double in value, given a particular fixed rate of return.  Please take note that this only works with a fixed rate of return.  The actual formula is as follows:

72/R = Y (where Y = the number of years to double the value of an invested amount, and R = the fixed rate of return)

So, if you were to invest $1,000 at a rate of 4%, it would take 18 years to double in value to $2,000.

Another way to use this formula is to determine the fixed rate of return that you would need to achieve in order to double the value of an investment within a particular known timeframe.  This is possible because the formula can be rewritten as 72/Y = R as an equivalent.  Here’s an example:

If you had $1,000 and you wanted to double the value to $2,000 within 10 years, you would have to achieve at least a 7.2% return to accomplish this.

Rule of 78’s

This rule is useful for calculating loan interest being paid with each payment of an loan, or the accumulated amount of interest paid to date.  The name comes from the fact that when the numbers 1 through 12 are added together, the result is 78.   But why is that important?  Don’t fret – we’re getting to that part!

You’ve heard that most of the interest is paid first in a loan, right?  It’s true: interest in common Rule of 78’s loans (also called “sum of the digits” loans) is loaded toward the front of the pay-back cycle.  The way that interest is paid off in a 1-year (12-month) loan is as follows:  in the first month, 12/78ths of the interest is paid; in the second month, 11/78ths; third month, 10/78ths; and so on until 1/78th is paid in the final month.  The remainder of each fixed amount of payment each month goes toward the principle.

So using the Rule of 78’s we can figure out how much interest has been paid at any one time (assuming the payments are paid exactly as prescribed, no additional payments or late payments have been made) by adding up the Rule of 78’s factors up to the present month.  If we know that the total finance charge for our one-year loan is $200, and we’ve made four payments, we can see that we’ve paid $107.69 in interest so far.  This is calculated as:

(12+11+10+9) / 72 * $200 = $107.69

But what if our loan is for 36 months instead of just one year?  This is where the alternative name, “sum of the digits” comes into play… Of course adding up the months of payment won’t equal 78 – when we add 1 through 36 together we get 666 (ominous, I know!).  Following what we discovered about a 12-month loan, we know that in the first month, 36/666ths of the total interest will be paid; during the second month, 35/666ths; and so on.  Knowing what our denominator is now, we can cipher the amount of interest that will be paid with the 20th payment – 17/666ths – for example.

Keep in mind that the Rule of 78’s calculations are only useful in “pre-computed” loans – such as auto loans or mortgages.  For revolving loans (like a credit card), you pay interest currently each month (or the interest is added currently if you’re not paying the interest amount).

Have fun and “rule” your financial universe!

Photo 1 by omniNate
Photo 2 by Bull-Doser

(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb.  Therefore, we’re talking about Rules of Thumb.)

I like rules of thumb, as a rule of thumb… I think we all want for most difficult issues in our lives to be boiled down to a simple, easy to understand statement.  These rules are everywhere, all around us, cropping up more and more every day.  Heck, there’s even a whole website dedicated to rules of thumb, where you can find rules on all kinds of subjects, as diverse as how to outrun a crocodile to changing your answers on a test.

With the popularity of rules of thumb in mind, I wanted to address a few financial rules of thumb that you see pretty regularly – and assess whether they’re useful or not…  This may become a somewhat regular feature. Today we’ll start off with an age-old rule:

Save 10% of Your Income

Let’s start with one of the basics you see all over the place:  Save 10% of your income.  Like most all rules of thumb, this one is very general in nature, and likely doesn’t apply to much of anyone in particular – but it does provide a good starting point.  This starting point is best for someone starting the savings process at an early age – perhaps in your twenties or thirties.  If you started to save 10% of your income at that point and kept up the habit over your lifetime, you’d be bound to have a significant sum of money put aside when retirement comes.  (You might be interested to note that this particular rule of thumb is one of the base recommendations in the book “The Richest Man in Babylon” which I wrote a summary of some time ago.)

The problem is that many folks don’t start early in life, and by the time they get around to saving in earnest (maybe in their forties), 10% savings will likely be woefully inadequate – 25% to 30% may be more appropriate.

The other, likely bigger problem with the 10% rule is that it doesn’t account for your timeline or the purpose or goal for the savings.  The assumption is that you have a long timeline, meaning 30 or more years, and that your goal is retirement at some poorly-defined rate of income, such as 80% of pre-retirement income (see below).  These two assumptions aren’t likely to fit everyone – although they could fit some people in general, your mileage may vary, quite a bit.  If your timeline is shorter (say 10 to 15 years) or your goal is for a higher retirement income your percentage of savings should be higher, possibly much higher.  If your goal is something altogether different, like a downpayment on a home (in a short timeline but of a specific, small-ish amount), 10% would be too much – although you will likely benefit on other goals by saving at least 10% at any time.

So, for a starting point, for someone with a relatively long timeline and a vague goal to aim for, 10% isn’t bad.  Start with this and adjust upward over time.  It’s better than no rule at all, in my opinion.

Let me know if you have a particular rule of thumb that you’d like me to feature – you can leave a comment below or use one of the other methods to get to me (listed on the right side of the page).

Photo by akeg