Financial rules of thumb are handy. They give us a quick and easy way to make important financial decisions. They are a good starting point.
These rules of thumb, however, should be used with caution. It would be wise to think of them as Capt. Hector Barbossa viewed the pirate’s code, more of a guideline. The truth is that financial “rules” might not apply to everyone, and you need to be cautious about how you interpret and rely on these rules to make big decisions.
Here are some examples where they may not be the best advice.
Table of Contents:
1. Save 3 to 6 month’s expenses in an emergency fund
The appropriately-sized emergency fund is a cornerstone to financial stability. Many experts say that three to six months of living expenses is ideal. Dave Ramsey says to save a $1,000 emergency fund. Suze Orman recently changed her view, now espousing an eight month rainy day fund. Eight months! If your monthly living expenses are $5,000, should you really save $40,000 in a savings account?
The answer isn’t really in the experts’ recommendations, it’s in your own situation. How stable is your income? Could you reduce expenses in an emergency, if necessary? How flexible are you with the location you live and changing jobs or careers should you need to? Do you have access to funds through a line of credit or a 401(k) loan?
Takeaway: Use the “three to six month” rule for emergency funds as a guide, but don’t be afraid to go above or below this range based on your individual circumstances.
2. Buy life insurance equal to 12 times salary
The point of life insurance is to replace your income and support your family or beneficiaries adequately in case you’re no longer there to do so. Multipliers like “12 times salary” are a popular rule of thumb for determining how much you need. But that’s really just a rough starting point. What you actually need varies widely, and needs to be assessed on a personal level.
Instead of settling for a certain multiple of your salary, consider important questions.
- Where are you in life? If you’re in your 20s with a family, you’ll likely need more insurance than if you’re older.
- What do you want to accomplish? Do you want life insurance to replace your income for life, or just to cover a certain period of time?
- Do you have a lot of debt? If yes, you may want more insurance to cover it.
- Do you loved ones have earning potential? As important as your income may be, your spouse or significant other may be just as capable when it comes to bringing home the bacon.
Takeaway: Use “12 times your salary” as a starting point for the life insurance you need, but calculate a more accurate figure based on your personal situation.
3. Pay off smallest debt balance first
The debt snowball, popularized by Dave Ramsey, has become a popular method for paying off debt. The theory is that by targeting the smallest balances first and ignoring interest rates, you’ll increase your motivation as you pay off individual debts.
While the disadvantage of paying more interest is often mentioned, the true cost of the debt snowball isn’t always laid out. The well-disciplined that don’t gain a psychological advantage with the debt snowball will save more money by targeting the highest interest rates first.
Takeaway: If saving money motivates you over paying off a low balance debt, stick with paying highest-interest accounts first.
4. Max out your 401(k)
You can’t go wrong investing as much as possible in your 401(k). Or can you?
Investing in a 401(k) is an especially good move if your company is matching your contributions. It’s free money.
But once you’ve maxed out matching funds, putting more money in your 401(k) may not always be the best move. Instead, consider investing in a Roth IRA. You investment will grow tax-free, and you may have more freedom in the funds you can invest in compared to your company’s options. Alternatively, you may want to use the money to pay off high-interest debt or build up your emergency fund.
Takeaway: Contribute to your 401(k) as long as your company matches your contributions, but consider a Roth IRA after.
5. It’s better to own than rent
It’s true that with buying a home, you’re building equity and hoping your investment increases in value. But historically speaking, home ownership may not be as good an investment as you imagine. CBS News reports that from 1890-2005, ” inflation-adjusted home prices rose just 103 percent, or less than 1 percent a year.” That’s not much of an investment.
Renting isn’t always a money-loser, either. Renters have more flexibility to move without having their money tied up in a house, don’t have to worry about maintenance costs, don’t have to pay real estate taxes, and don’t lose six percent to realtors when it’s time to sell.
The point here is not that owning a home is a bad move. One big advantage is the tax breaks you get on any gain from a sale, not to mention the non-pecuniary satisfaction many enjoy from buying a home. But don’t assume that owning always beats renting.
Takeaway: Both owning and renting have their pros and cons. Look deeper to decide if buying is the right move.
6. Save at least 10% of your income
Saving 10% of your income is good advice and probably better than average. But it’s not ideal in every situation.
If you’re dealing with high-interest debt from a credit card or auto-loan, you may be better served to pay down your debt before saving anything. Your investments are unlikely to dwarf the high interest rates from credit card debt.
For retirement, saving ten percent may or may not be enough. In your 20s, saving 10% may put you ahead of the game because of the time you have before retirement. If you’re just starting to save for retirement at age 50, however, you’ll likely need to save fare more than 10%.
Takeaway: Saving 10 percent is a very general recommendation. Look at your current needs, like paying down debt, as well as what you’ll have saved in retirement to decide how much you need to save.
7. Limit student loans to your first job’s expected salary
College students often think little about the consequences of taking out student loans. The mentality is often “I’ll pay them off easily once I have a high-paying job.”
A typical limit you’ll hear is to keep loans under the expected single year salary of your first job. Giving the green light to borrow this much isn’t always a good idea.
To start, paying off student loans of any amount can be tougher than imagined. Plus, graduates will need to find a job to be able to pay back anything, which isn’t an easy task in today’s market. Finally, some degrees are in industries where you can expect your income to grow substantially over your career, while other degrees are in stagnant fields. A software engineer might start at $70,000, but see his or her income quickly grow to six figures. In contrast, a high school teacher likely won’t see his or her salary rise be nearly as much.
Takeaway: The job search and your salary after college can be hard to predict. Work to minimize loans no matter what you expect to make at your first job.
8. Buy a used car instead of new
Buying a used car can save money. A car depreciates in value once you drive it off the lot. Buying used helps avoid these losses.
But there are times when the math is close, and buying new can be better. Often the longer you own a new car, the better deal you’ll get compared to buying used. The savings from keeping a car longer can often make up for paying the premium to buy new.
Takeaway: Consider important variables, like how long you’ll own a car and maintenance costs. Keep in mind that cars don’t depreciate at the same rate; some hold their value longer. If you’ll own a new car for a long time, buying new can end up being a better deal than buying used.
9. Choose term life over whole life insurance
It’s true that term life insurance is less expensive than whole life insurance. Whole life insurance costs more because it includes costs over and above the actual cost of insurance. These additional costs are invested and can provide cash value. The problem is that the fees and expenses associated with this “forced savings” can be exorbitant.
But whole life insurance does have some advantages. They can be useful for estate planning, may have some tax advantages, and can provide permanent life insurance. As a result, whole life insurance can be helpful for those who have special situations like handicapped children that will need care long after their parents have passed. Term insurance, as its name suggests, lasts for a set amount of time and then expires.
Takeaway: Consider whole life insurance as an option, but don’t let an insurance salesman talk you into it. See advice from an insurance specialist who won’t profit from your decision.
10. Always avoid credit cards
Money expert Dave Ramsey is strongly against credit cards in all cases. It’s hard to argue he’s wrong when the total credit card debt in the U.S. stands at about $858 billion.
While some consumers undoubtedly have huge debt problems due to credit cards, others use them responsibly and get huge benefits over cash. Between the convenience over carrying cash, consumer protections, and the amazing rewards available, credit cards can be a positive part of your financial toolbox. Credit cards can also help you build your credit score.
Takeaway: If you’re disciplined, credit cards can be a valuable tool.
11. Plan for needing 80% of your salary in retirement
This isn’t a bad retirement “rule of thumb” and creating your savings goals with this in mind may work out just fine. But there’s one problem: it’s based on some big assumptions, that may not be true for you and your family.
You may make significantly more or less now than you’ll need in retirement. Depending on your age, it may be extremely difficult to predict your expenses during retirement. You may live with your children or own three homes and travel the world. My friend Mike Piper wrote an excellent book on this topic called Can I Retire? I highly recommend it.
Takeaway: Use these rules as a guide, but realize there are no guarantees that all the math with your investments will work out. Considering saving more to compensate for uncertainty.
12. Spend 3 times your income or less on a new home
Ready to buy a home? A quick search might turn up the recommendation to spend 3 times your income or less.
While this rule is a sensible place to start, income isn’t all that matters. Factor in the debt you already hold and home ownership expenses like taxes, insurance, and maintenance. Don’t forget that interest rates along with the monthly payments you can actually afford will play a big role, too, regardless of the actual price of the home.
Takeaway: Keep the “3 times your income” figure in mind when shopping for a home, but look more closely at other financial details for how much house you can afford.
What other financial “rules of thumb” should we add to this list?