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?
I remember when purchasing our first home in the early 90s. the rule of thumb that I took to heart was to have a mortgage that was up to 3 x annual income. We applied the same wisdom when purchasing our second home in the late 90s. That put us in a very difficult situation when my husband went through a job loss in the early 2000s. I don't think that 3 x annual income is a rule of thumb any more, and I'm not sure why it ever was. Strangely, it was my mom, who has actually always been very good with money, who passed that bit of "wisdom" on to me. Perhaps if the mortgage had been our only debt, it wouldn't have been so bad, but that's a rule of thumb I will never pass on to anyone.
That’s another one I thought about including, but I think I forgot about it haha. But it’s true! People use that as an excuse to spend that much on a home, but it’s just not necessary
I have health problems, so I pay higher premiums. There's no way I want to spend enough on insurance to get 10-12x my yearly. Eesh. I got life insurance because I'm the wage earner in my household. If something happens to me, I need to make sure that my husband can pay off the house and have a bit of a cushion. We have a small mortgage of about $80,000, so $150,000 is plenty to keep him afloat for a bit. I also told him that if he wastes too much of the rest I'll haunt him.
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Sorry to hear about your health problems 🙁 But I like the haunting idea 🙂 I'll have to use that one on my wife!
I recently wrote how, during a real estate licensing class, we had the misfortune to have a guest speaker, a mortgage broker. She was looking to promote her business, but managed to turn me off with one slide in which she showed a 43/50% qualify ratio. You think 28/36 might be bad? This gal will get you a loan 50% higher than that. 43% to the mortgage? This probably does leave much room for the 10-15% to retirement. Big house, but no prospects to ever retire? No thanks.
I threw her card out.
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That's ridiculous. But I guess all some of them care about it getting that commission. Who cares if the people can't afford it over the long-term?
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I agree that saving 10-15% of your income for retirement is not nearly enough, especially if you're a low earner. You'll never retire at that rate!
It's true! The people who say it's a good savings rate are the people who don't plan on having any sort of income increase ever. Sounds like a sad way to live to me.
My recent post Rules of Thumb to Ignore
Love what you said about how people think it is okay to have "X" amount of debt simply b/c the mortgage company says they can. Life with NO debt is SO much better than life with debt, period!
YES! I can't wait for that day when we're completely debt-free. It will be glorious!
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I have a Roth 401(k) which I think is the bestest thing ever! I've never heard that 36% to debt rule before, but it does indeed sound dumb. However, I advocate having an e-fund while paying down debt so whatever percent allows you to do both.
When it comes to saving your salary for retirement I have mixed feelings. MMM's rules are not just impractical for folks with debt, but those like me who are living with a lower salary in a major city with a high cost of living. I save about 25% right now between the 401(k) and personal savings accounts. It's all I can swing with my rent eating up 53% of my monthly paycheck. But the more I make, the more I will obviously start contributing to savings/retirement. It's also a time game. Starting the investing younger (even with less money) gives you a massive advantage over delaying 5,10,20 years.
I agree that MMM's rules aren't very helpful for a lot of people, but it's definitely important to realize that there is a way. And yes, Roth 401(k)s are awesome! I had one for a while with a previous job and loved it!
Hi Ben,
I agree with everything you've said however people should max out your 401K first. Once you've paid your taxes you've locked that "loss" forever. You can control your tax rate, when I get a chance I'm going to write a post on this.
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Thanks for the comment, Charles. I look forward to reading your post on it!
Reading your post made me realize a lot of things but primarily the need to reassess how much am I really able to save at present that should go towards my retirement. Dear heavens, let the answer be positive because I am not getting any younger and my income is yet to grow bigger.
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It's kind of scary sometimes, isn't it? We haven't been able to put anything toward retirement lately because of my job situation, but I know we'll get to where we want to be eventually 🙂
I think Life Insurance isn't really meant to leave someone stinking rich, but to leave the other person comfortable. We have enough to pay off the mortgage and about 2x annual salary on top of that.
Sometimes it's nice to question where those pieces of advice are really coming from.
Also, I am in awe of MMM as well!
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I agree, it’s most important that your family is well taken care of. The definition of well taken care of is going to be different for different people, but if you look at it that way, you can’t really go wrong.
I wouldn't say it is a rule of thumb but more of how we have been socialized to believe that the only choices we have are to go to school, get a corporate job, get married, buy a house, buy a bigger house, have a baby or two, get a dog, install granite countertops, wait for our pension and then retire and golf all day until we need a walker. I am livin' that dream. Wow, sorry this sounds really negative. I don't mean to be and what I think I am trying to say is maybe we should start making new rules. It is nice to see people talking about it breaking the rules.. Cheers.
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Love it! No, you're spot on. I don't think you're being negative. I think that the norm is one big negative. It precludes us from putting more thought into our dreams and makes us little more than sheeple that wander around doing things just because we've been told that's how it works.