Financial rules of thumb are everywhere. No matter what you’re trying to do with your money, there’s at least one general recommendation you can follow to help you manage your money more effectively.
“Finance is an area that causes people a lot of stress,” said Justin Harvey, a certified financial planner who is the president of Quantifi Planning. “Rules of thumb provide some sense of certainty and concreteness. It gives them a sense of direction.”
Rules of thumb are a great goal to have when you’re starting out, but they can give you a false sense of security if you aren’t careful, he said.
5 financial rules of thumb that can limit your potential
Personal finance is personal, and you might have financial needs and goals that require you to go above and beyond what the general rules of thumb recommend. If you stop too short, it could end up being costly.
Here are five money rules that can be helpful when followed, but also can be harmful if you don’t personalize them.
1. Follow the 50/30/20 budgeting rule
There are different budgeting methods, but one of the most popular ways is the 50/30/20 rule. Using this method, you spend 50% of your monthly take-home pay on necessities, 30% on wants and lifestyle expenses, and 20% on debt and savings.
This rule is a simple framework that can help you determine if you’re spending too much on wants and necessities. But if you’re having trouble saving money or you’re buried under a mountain of debt, dedicating only 20% of your paycheck to that category likely won’t be enough to achieve your financial goals.
Instead, take a look at your full financial picture, including your debt payments and savings goals. If you’re having a hard time making payments or saving money, look for areas to trim in the other two groups. There’s no exact science to the process, so you might need to do some critical thinking about your goals and expenses.
2. Have 10 times your annual income in life insurance
Life insurance is a must-have if you’re married with debt or have people who depend on you financially. The right amount of life insurance coverage, however, varies by person and family. The rule of thumb, which is to have coverage amounting to 10 times your annual income, can result in getting more financial protection than you need or not nearly enough for your loved ones’ needs.
“[The recommendation] can cause people to overpay,” said Harvey. “Later in your earning years when you have less earning to protect, your insurance need is a lot less.” That’s because people typically have more saved up for retirement and won’t need the current income replacement once they’re retired. The same goes for younger couples who don’t have children or much debt.
Instead, use the needs-based method when calculating how much coverage you need. Start by adding up the costs of the following needs:
- Funeral and other final expenses
- Debt payments
- Income replacement (how much and for how long)
- Other expenses, including college costs for children and costs of other financial goals
From the total of all the numbers from these needs, subtract the following:
- Liquid assets, such as cash in a bank account or nonretirement investments
- Existing life insurance coverage
Since this needs-based method is personalized and specific, it should ensure that you get the right coverage for you and your loved ones.
3. Save for a 20% down payment on a home
Having enough saved for a 20% down payment on your next home can be a huge boost for your financial health. Not only will this help you qualify for lower interest rates on a mortgage than if you were to have a smaller down payment, but you’ll also be able to avoid buying private mortgage insurance (PMI).
PMI is an insurance policy that protects the lender from losing money if you default on your mortgage; it typically costs between 0.5% and 1% of your loan amount per year. For example, a $250,000 loan would result in a monthly PMI payment of $104 to $208 that you’d pay in addition to the mortgage installment.
For many people, however, saving enough to reach a 20% down payment goal could take an unreasonable amount of time, said Harvey.
“During which time, if they had purchased a home with an FHA loan, which requires less down upfront, it would allow them lifestyle flexibility much earlier,” he said, referring to loans backed by the Federal Housing Administration. “And while the monthly payments would be a little bit higher, the quality of life would be different and potentially much more favorable.”
Take the time to determine how much house you can afford now. If home prices in your area are relatively low or if you anticipate it will take too long to save for a 20% down payment, it might make sense to get into a home sooner even with PMI.
4. Save 3 to 6 months’ worth of expenses
Having enough savings to cover three to six months’ worth of expenses is not easy for a lot of people. A recent Bankrate survey found that 61% of Americans don’t have enough money saved up to cover an unexpected expense of $1,000 or more. For many people, saving even one month’s worth of expenses can feel like a stretch.
And saving even three to six months’ worth of expenses might not provide enough protection for your financial health. If you lose your job, there’s no guarantee you’ll find a new one within half a year. If you’re retired, a recession could deal a major blow to your investments that support you. That’s when a robust emergency fund could cover your costs while your retirement accounts recover.
If you haven’t reached three to six months’ worth of expenses yet, work toward that goal. But once you get there, don’t stop if you think you need more. Determine your emergency fund goal, and then keep saving more until you have the peace of mind you need.
5. Set aside 10% of your income for retirement
Roughly 42% of Americans have less than $10,000 saved for retirement, according to a recent survey by GoBankingRates.
“Most people don’t save at least 10%,” said Harvey. “So, if everybody did that on average, people would be better off.”
But once you achieve that 10% goal, don’t stop there. “When you’re saving, you’re purchasing flexibility in the future,” he said. “If you save at a higher rate, you can buy your future independence sooner.”
When you create your retirement savings plan, it shouldn’t be based on an arbitrary rule, but on how much income you want to have in retirement and when you want to stop working. Harvey recommends that his clients save as much as they can. While you save as much as possible, make sure to keep it balanced with your other financial goals and obligations.
Tailor the financial rules of thumb to your goals
There’s nothing wrong with using a rule of thumb to get oriented in the right direction. But once you’re on the right track, view the rule as a checkpoint rather than the finish line. Depending on your personal needs and goals, the money rules of thumb might be sufficient. But if they aren’t, they could end up costing you dearly.
Whether you need to build your credit, improve your cash flow, or boost your savings, take the time to plan out your financial goals and figure out how you can achieve them. If necessary, work with a financial adviser who can give you concrete guidance on steps to take. As you make these moves, you’ll be on your way to financial independence sooner.
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