Rules of thumb can be useful to help people who are completely new to getting their personal finances in order. It gives you a good idea of what is generally accepted as good financial behaviors. When I first started becoming interested in personal finance, they were largely my guide to setting goals and gauging my financial health, but the more and more time I spend looking at where I want to be 10, 20, and 30 years from now, the more I realize that a lot of those rules of thumb are just holding me back. Here are a few.
Save 10-15% for retirement
If you can manage to save at least 10% of your income, congratulations. You’re above average. If you’re saving 15%, you’re super. But if you make enough that you could save more, why let this hold you back? I’ve linked to Mr. Money Mustache’s site many times before, but I just can’t get enough of his article about the shockingly simple math to early retirement. If you can do it, why not? Is it worth having to go to work every day for 45 years just so you can fund wasteful and meaningless pursuits? Keep some balance, but keep asking yourself, “Is that the best you can do?”
If you’re dealing with high-interest debt, this rule of thumb is completely useless to you. Get rid of that garbage first because you probably aren’t going to find any investment that will beat what you’re paying in interest. Kill the debt first then do what you can for retirement. And once you get to that point, hit it hard so you don’t have to wait until you’re old and feeble.
Get life insurance equal to 8 to 12 times your salary
The point of life insurance is to take care of your family after you die. Some popular personal finance personalities and online insurance rate quote sites will recommend 8 to 12 times your salary, but you have to ask your question, “What is this money even for?” Personally, I love the needs-based approach. It actually sparks a conversation between you and the people you love. I would ask each spouse what they feel they would need in the case the other was no longer there. We took everything into consideration. Some would want to take a couple of years off from work to spend time with the kids, while others didn’t have kids and didn’t need that income. Some husbands wanted to make sure their wives never had to worry about money again, while some wives wanted to go back to work at some point. Some had a mountain of debt to pay off while others didn’t.
My point is that if you go with a simple rule of thumb on this one, you could be either wasting money on insurance you don’t need or selling your loved ones short. As a former insurance agent, I support the idea of working with an agent (GASP!). At the same time, you have to know that some life insurance agents have big thumbs. So if you don’t feel comfortable with that approach, think about all the different scenarios that can come up and make the best decision for you and your family.
No more than 36% of your income should go to debt
When you are looking to qualify for a mortgage, the amount they will approve you for depends on your income and your other debt payments. When doing their calculations, if the amount you are requesting has a payment that, combined with all your other payments, exceeds 36% of your gross income, you don’t qualify.
It seems crazy, but some people seem to think this means that because the mortgage company uses this rule of thumb, having 36% of their income going to debt is acceptable. This is NOT acceptable. It is meant to be a maximum, not an average. Your goal should be to have as little debt as possible, and if getting into a house is going to push that debt ceiling, you may be better off with renting until you can get your debt under control a little bit. Not all debt is created equal, and having a $100,000 mortgage isn’t as stupid as having $100,000 in credit card debt, but debt is debt, and if you can’t control your current debt, don’t add more to it.
Max out your 401(k)
Investing in your 401(k) is probably the easiest way to save for retirement. It also offers a higher annual contribution limit than an Individual Retirement Account (IRA) ($17,500 vs. $5,500), and a lot of employers will match a percentage of what you contribute (freeeeeee moneeeeeyyyy!!!) But does that mean it’s the best option? Well, that depends on your income and your goals.
Although a Roth IRA’s contributions are made after-tax, your contributions grow tax-free. So it really boils down to when you want to be taxed. If your income is relatively low right now, it might be better to be taxed now. If your income is higher than what you think you’ll be receiving in retirement, it may be better to put your money in the 401(k) and get taxed when it’s distributed. Also remember that 401(k) contributions are deducted from your current year’s income come tax time. You see? There’s more to it than you first think.
The moral of this story is that you should first max out the employer match. Then take the time to either go through the pros and cons yourself, or consult with a tax accountant to see what’s best for you.
What are some other rules of thumb that you hate? What are some that have been helpful for you?