#63: My Favorite Financial Rules of Thumb

Welcome to the Passive Income MD Podcast where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Hey everyone, hope you've had another amazing week. Before we get to this week's episode, I want to give people a heads up, a save the date of sort. Just wanted to let you know that in a couple months, September 10th through 12th, to be exact, we're going to hold our third annual PIMDCON, which is also known as the Financial Freedom through Real Estate Summit. This year, like last year, is going to be a virtual summit. I'll be honest with you, I would love to get back to live events and I think that maybe next year we'll make maybe be able to do a virtual live virtual event. But for this year it will be virtual. We may have at least like a live component get together for those who are local to the Southern California area or willing to fly in or visiting friends or that sort of thing for that weekend. But we'll let you know about the details. But in any case, wanted to have you save the date. Like last year where we almost had about 10,000 participants. We'll be talking about all aspects of real estate for physicians and high professionals, from active investing, you know, that's direct ownership, to passive investing, which is investing in like syndications and funds and other deals and everything in between and topics related to that. So there'll be a ton of experts. It's going to be a lot of fun and just save the date for that. Okay, PIMDCON 2021. We'll see you there. And let's get on to the episode. You know, when it comes to finances, it can be really tricky. I mean, it doesn't matter whether we're talking about buying a rental property, investing in crowdfunding, deal retail, or even just making a budget. It's really easy to get caught up in all the minutia, all the details, and I'm definitely one that finds myself in that situation. I don't know if you're like that. Sometimes there's a little bit of overwhelm, you know, when it gets to thinking about a lot of these things and making sure you're doing things correctly. In fact, it also leaves room for this whole paralysis by analysis or analysis paralysis, however you like to call it. That happens to us where we just have to think about so many different things that it's hard to take action and, and it's hard to actually know whether we're doing a good job. You know, in times like this, things that have really helped me to understand where I'm at are these different rules of thumb for each situation. Now, if you're considering an investment or a purchase, especially having that rule of thumb allows you to quickly analyze a situation, have a quick idea of whether it's worth your time to pursue it or analyze it further. So honestly, think of these rules of thumb that as a basic guide to help you make that quick snap determination. Now, thinking more big picture, rules of thumb also come in handy if you're looking to assess your own situation, especially if you're wondering whether you're on track with your own current financial goals. For example, having those rules of thumb, like kind of the top of your mind, make it really easy to figure out whether you're in the right ballpark, right, or on the right trajectory. Now, of course, just want to let you know, these rules don't apply to every single situation, every single person. But again, it's just a basic one way to know whether you're on the right track or not. So here is a list of some of my favorite financial rules of thumb. The first one is whether to buy or rent. And this comes to your own personal situation. You know, I used to always think that it was kind of rite of passage as a physician to go buy your own home. And I did just that coming right out of fellowship. But there might be a situation where it might be better to actually rent your own home, take that money, put it towards a rental property or something versus buy. And there are rules of thumb to help you better determine that. And one way is to use something called the price to rent ratio. Again, it helps you decide whether it's better to rent or buy in your situation. What you do is you simply divide the rent you would pay in a comparable place into the sale price to get this ratio. For example, if you find a home that costs $250,000. Now, it's not possible in my area, but let's say the home's renting for $800, 1800amonth. That would equal about $21,600 per year in rent. So it's 1,800, right, for the rent times 12. So what you do is you take that $250,000 purchase price, you divide it by 21,600, and that equals a certain number, which is your price to rent ratio. So if you have a Paper handy. Quickly do that number in your area and see what number you get. See what that ratio is. Now, if it's greater than 20, people say it's better to rent than buy. Now, if it's less than 15, it's better to buy than rent. Now if it's between that 15 to 20 range, it's kind of that gray area where you have to take a lot of other factors into account, such as like, how is the overall market doing, what direction is it trending in, how are rents progressing and just kind of your own financial situation to figure out what's correct. Now, what is your price rent ratio? I'm curious now, and especially now if you're thinking about buying or renting a home. Now, if you are deciding to rent a home, here's a second rule of thumb. How much house can you afford? Now, I know most people simply just go by what the bank tells you. The bank will lend you out as much money as they can reasonably, and most people will honestly purchase a home up to that price. But is that the smart financial decision? Now this can vary. Most people will say it is anywhere from 2.5 times to 4 times your annual salary. Now if you're trying to be conservative, most people say it's somewhere between 2.5x to 3x your salary. Now the reason this is a good rule of thumb. It allows you to purchase a home without overstretching and putting yourself in a house poor situation. The lenders again have their own situation which they actually use some rule of thumb kind of close to this, but it's a good estimate for you to use, especially when you're out there looking. Now, to be honest with you, if you live in a high cost of living area like I do in Southern California, something in the 2.5x range might be tough in terms of helping you to find your own home. So you might have to relax that a bit to get the home in the right school district and that sort of thing. But again, it's a good rule of thumb to make sure you're not overspending in this area. Now, let's say you're trying to buy a rental property. This is called the 1 or 2% rule. This rule states that your investment Property should rent for 1% of the purchase price. So let me say that again. The rule states that your investment Property should rent for 1% of the purchase price. For example, if you buy a five unit apartment building for $800,000, 1% of that is $8,000. And so you should be bringing in $8,000 a month in rent. Now what this rule does is that it likely ensures that you're going to be in a cash flow positive situation, or at least a cash neutral situation. When you buy a rental property, people have different goals for it. I've always said that my goals for rental property are to have some appreciation, but primarily cash flow. I want a situation where I can use that income on a monthly basis to live however I want to live. And so that 1% rule, at least on initial analysis, helps me do that. Now, in certain markets it may be quite difficult. People used to use the 2% rule, but to be honest with you, I don't know of any properties these days that really satisfies that 2% rule. But at least the 1% rule is a great place to start. Another rule of thumb when it comes to analyzing your own rental properties is the 50% expense rule. This rule states that the expenses for rental property, apart from the mortgage, it's likely going to average about 50% of the rent. So it helps you to quickly estimate monthly cash flow. Here's an example. This property that I mentioned above, that brings in about 8,000amonth in rent, assume that 4,000 of it, right, 50% of it will go to expenses. And what are some of those expenses? Management, maintenance, vacancies and all other expenses involved, you know, apart from the mortgage. So if you have $4,000 left and the monthly mortgage is $3,000, then assume that you're gonna have about a thousand dollars left as cash flow per month. That'd be amazing. And so people use this rule to quickly identify rental properties that would cash flow. You know, not only using the 1% rule, but also using the 50% expense rule just as a quick check to say, hey, this might be worth doing a little bit more due diligence for now, this rule will over or underestimate things. I promise you it's going to be one or the other. Rarely does it land exactly on 50%, but it depends on a good number of factors like does the building require a significant amount of maintenance, Is this a newer property versus older property? Do you have a property manager in this situation or are you going to self manage? Or is it the type of property where you're going to have a lot of turnover or maybe you're going to have a lot of, you know, less turnover or maybe you're going to have longer term leases. And these are other things to consider when you kind of think about these expenses rule. Alright, now that's when it comes to buying homes, whether it's for your own home or rental property, those rules. Now let's talk about personal finances and retirement. One of my favorite rules when it comes to budgeting is the 50, 30, 20 rule. Now I don't budget down to the exact dollar. I never have and I hope I never will. I tend to make sure that my income exceeds my expenses. We try to live, you know, comfortable, we spend well on experiences and things like that and travel and whatever it might be. But we tend to not overindulge on other type things. And so we've never really had a problem with our monthly cash flow. However, when I do look at it on a global basis, I like to use the 50, 30, 20 rule. And I don't know if you've ever heard of it or what you use, but here's the rule. 50% of spending goes towards basic expenses and necessities. That includes your housing and bills. Now 30% goes towards spending towards dining and entertainment. I love that. 30% towards dining and entertainment. 20% goes towards saving towards retirement and paying down debt. So that's a great rule to follow. 50, 30, 20 rule. Now when it comes to saving for retirement, people say that 20% or 10%, whatever you're comfortable with. I think that the white coat investor, he'll say that saving 20% every take home income should be the mark for physicians. And that will set you up nicely. It'll make sure that you're paying yourself first, taking care of your future while still leaving enough for you to enjoy life. Now they say that the average American saves less than 5% and I think that's setting yourself up for a bad situation. So don't be that person. Now how about emergency fund? Do you have an emergency fund out there? I think many people do. What emergency fund is, it's a fund that you put set aside for a rainy day, unexpected expenses, whether it comes to housing, medical bills, whatever it might be. Now most people say it should be about three to six months of your monthly expenses. So whatever your monthly expenses are just a ballpark figure, let's say that comes out to $10,000 for example. Then make sure you have at least three to six months of it stocked away at any given time. So 30 to $60,000 in a easily accessible account, like a, maybe like an online savings account. Now the amount that you have should depend on what your income sources are and how consistent they are. To be honest with you, I don't really have a emergency fund personally. I have other income Sources coming in on a monthly basis. I have multiple streams of income and that's kind of like my emergency option, knowing that if one goes down, I have others coming in. I also have opened up a HELOC in the case that I need quick access to capital. But it's to each their own. I think it's your level of comfort with your own income. But either way, you should know where you can draw from in the case that something happens, whether it's unexpected, you know, health issue, job issue, and that sort of thing. Now, here's another rule. Have you ever heard of the 4% rule? Now the 4% rule is pretty common, especially in the fire or the financial independence, retire early world. So in my world, when I deal with like my good friend's financial, you know, physician on fire, he talks a lot about the 4% rule. And what it is is that this rule states that you can withdraw 4% of your savings each year, and depending on your allocation, it should last at least 30 years with about 95% certainty. There were certain studies done which kind of back tested and tested this whole 4% concept, and it seemed to hold up very, very well over time. Now, the only thing they took into account was a stock portfolio or stock and bond mix. And a lot of people use this to determine whether they're financially independent or not. So what they'll do is they'll look at their whole nest egg and let's just say, for example, it's all in stocks and bonds and they have a couple million dollars in there and they'll take 4% of that and they'll say, can I live off that amount? And if I can, then I satisfy the 4% rule and I'm in a position where I'm financially independent. And so people use that and it's turned to work out quite well. Now whether this is successful or not can depend on something called sequence of returns, meaning that if you pull out more or at least a 4% early in your retirement and the stock market happens to be on a downward trend, then it's possible that you may run out of money later on in retirement. Whereas if early on the stock market does quite well, you're still pulling out that 4%, then you're better set up for the future. And so what people do is that they tend to be a little bit more conservative early on in their retirement. Maybe they draw 2 and a half or 3%, especially if the market seems to be on a downward trajectory to make sure that they don't end up in situation where that money runs out in the future. Now, as most of you listening to this know, I don't have a huge allocation in stocks and bonds. I do have some in there for diversification sake. And I tend to use more of the cash flow independence model where I know that if I have X number of income coming in per month from my passive income sources, mostly real estate related, both active and passive investments, then I know that I can just stop working in terms of my medical, you know, clinical career, and I know that I have plenty of income to support my expenses. I think it's an easier way to think about things, at least for me. And that's what I've used to gradually retire over time and it's helped me. But for those of you who have a significant allocation of stocks and bonds, the 4% rule should guide you well. Now, another way to think about this 4% rule, just a way to kind of flip it, is a 25 expense rule to knowing whether you're financially independent or not, basically using that same 4% rule. Another way to think about it is that if you multiply your annual expenses by 25 times, that's what you ultimately need to be financially independent. It's like taking the 4% right, dividing by 25 or multiplying by 25, it's the same. But it's another way to think about it. Some people be more conservative and they'll take their annual expenses, multiply it by 30 and then they'll say if you have that much in your portfolio, then you're good to go and you're financially independent. Now how do you know that you're on the right track with your net worth and your finances? It'd be good to know, right? It's hard to compare because as physicians definitely we're somewhat developmentally delayed when it comes to our finances because we aren't training for so long. We accumulate a significant amount of debt and then we typically have higher salaries, right? So we start a little bit later on in life. But it's nice to know whether our net worth is, is at least trending in the right direction. The basic rule of thumb when it comes to your net worth is that you should take your age, you divide it by 10, and then you multiply by your gross annual income. That's the basic rule of thumb and that's what your net worth should be. Now let's put that into numbers. If you're a physician and let's say you're 40 years old and you make $200,000 a year, your net worth should be $800,000 at this time. So how do you calculate that? You take your age 40, you divide it by 10, you get four, you multiply that by your annual salary, $200,000, and that gives you a number of $800,000. Now that would be a nice number to make sure that you're on track, to make sure that you're in a good financial situation, at least stable and moving towards your retirement goals. Now, your net worth, for example, it doesn't tell you everything. It doesn't tell you whether you can retire or not. Your net worth by itself, like how much of it's liquid, can you live off it? Can you retire? So it doesn't really serve those type of purposes, but it's nice to know that you're on the right track in terms of SA and investing well. Now obviously as physicians, we typically hit a positive net worth a lot later on in life because of our student loan debt. And to be honest with you, we're probably moving in a the worst direction when it comes to that stuff. So it's not super applicable, but it's nice to know where we sit according to the general population. Now, your net worth is probably something that you should be tracking not on a super meticulous basis, but at least on a monthly basis to know, or at least a quarterly basis to know how well you're moving in terms of the right direction. Now you should be trending towards a positive right. Moving in the positive direction versus the opposite. You can do that by writing it all on spreadsheet, doing it by manual, or you can use something like an online automated process like either mint or personal capital. I use personal capital. All right, and then our last rule of thumb has to do with life insurance. Now I never had life insurance until I got married and bought a house. And especially when I had kids. I kind of re examined it. And most people will re examine it along the way because you can always add onto it, especially when it comes to term life insurance. And people always wonder, how much life insurance do you need? Now here's a simple rule of thumb. There's basically two of them. The first one is just take your income and you multiply by 10. Now this takes into account your income and your expected lifestyle that you have along with it. So if you again make $200,000, you should probably have about $2 million worth of life insurance. The other rule of thumb is that you take Your income times 10 and then you add another 100,000 for each child for higher education expenses. Now, as we all know, probably that's not going to be enough to Support our kids. $100,000. You may want to add 200, 250 if not more for those expenses, at least to put them on the right footing. Maybe you won't be able to cover all of it, but income times 10 plus 100. You know, I tell people $250,000 to account for higher expenses and that provides you a nice cushion. Now, when it comes to term life insurance, to be honest with you, depending on your, I guess, health situation, it's relatively affordable. And so it's something that you probably want to set up earlier on in life and make sure that you create a nice term. So that will cover, you know, at least your kids growing up and make sure your house is relatively paid off and it puts you in a good financial situation. How many of those rule of thumbs have you followed or used in the past? I'm always open to hearing more. I love using rules of thumb because again, it simplifies a complex situation and it just allows you to make a quick back of the napkin type calculation or front of the napkin calculation to determine whether you're in the right position or you should spend more time and energy on a certain situation. So anyways, hope you had a great week. We'll talk again next time. And again, mark your calendars for PIMDCON 2021. We're super excited about that and I think you'll completely enjoy that. So take care. Bye. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us in. 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