Everyone loves shortcuts. Financial rules of thumb are no exception. Who has the time to build elaborate spreadsheets to decide between alternatives? Having quick rules to guide your decisions is helpful, but only if they are the right rules. On that note, even the “good” rules don’t automatically apply to every situation. Personal finance is, well, personal.
With that warning in mind, I wanted to highlight four common rules of thumb that I hear often. Two of them are useful, the other two not so much. Use this list to check your thinking! Be sure to take note of specific instances where the rule needs to be tweaked to suit your circumstances.
GOOD: The 6-month emergency savings fund
You have probably heard the recommendation to set aside 3 to 6 months worth of living expenses in a savings account. The nay-sayers would argue that this rule forces you into low-interest paying bank accounts, but I think that the benefits of this recommendation outweigh the potential loss of interest income. An emergency can push you to make desperate financial decisions like using payday loans or skimping out on essentials like health insurance. A reserve of money can buy you peace of mind and time to make better decisions.
It is worth noting that your personal circumstances may warrant you to build an even larger reserve. If you are self-employed, it is smart to save more for those time in between paid projects. If you have a medical history with significant out of pocket expenses, a larger savings balance will give you more peace of mind.
MOSTLY GOOD: Save at least 10% of your income towards retirement
As quick rules of thumb go, the recommendation to save 10% of your income towards retirement is a good starting point. If you have not begun to think about your needs in retirement, 10% gives you a nice easy number to work with. It ensures you are building a habit of saving. The caveat here is that this quick formula does not consider your expenses in retirement. It also doesn’t take into account how much you have saved so far and how many years of pre-retirement saving you have before you. If you are playing catch-up, want to retire early or wish to use your retirement years for travel, you may want to save more than just 10%.
BAD: Buy as much home as you can afford
The real estate industry wants to trick you into buying as much home as you can afford (and sometimes even a little more than that). Following this mantra is the quickest way to get roped into a mortgage that you can barely afford. It also spares you no breathing room in the event of a financial snag like loss of a job or an injury. Do yourself a favor and take your realtor’s advice on how much mortgage you can afford with a grain of salt. He or she is not a financial specialist! There is also a conflict of interest to consider: your agent gets compensated based on the value of the transaction. Your best bet is to work with a trusted financial planner who knows your personal situation and your goals.
UGLY: Basing your retirement savings on 70% of your pre-retirement annual
You have probably heard the recommendation to base your retirement savings on 70% of your pre-retirement income. The problem with this rule of thumb is that your lifestyle is driven by your spending – not your income. When you are thinking about your spending in retirement, it is safe to assume that you will spend as much as you do now, or possibly more. If you want to be conservative, use 100% or 110% of your current expenses to estimate your needs in retirement. Remember that special consideration is necessary if you plan to move in retirement.
Financial rules of thumb: buyer beware
As with any money advice, it is a good idea to use caution with “one size fits all” recommendations. Rules of thumb are meant to be quick shortcuts: tools to help you make good decisions in the moment. They are not a substitute for qualified financial advice. No matter what your situation is, big decisions like buying a home or choosing an investment plan can benefit from a careful review by a trusted professional. Also, if your financial plan is more than 10 years old, it may be time to revisit assumptions and goals to be sure that your map does not lead you astray.