There are a lot of financial rules of thumb that are thrown around in articles, on TV, and by so-called personal finance “experts”. What are some of these rules of thumb and what could be wrong with using them for your personal situation?
Emergency Fund
The most basic, and maybe most widely used, rule of thumb is 3-6 months (or is it 6-12?) of expenses set aside in an emergency fund. The idea is to have cash available to pay for expenses that will not go away if you lose your job, become injured and can’t work, or something else happens unexpectedly that you have to pay for.
Don’t get me wrong, I think that it’s great to have cash on the sidelines in case something happens and that you should be prepared for the unexpected, and most Americans certainly aren’t, but telling everyone that they need a certain number of months of income in cash is too general.
Some people have a spouse whose income would be able to support the household if the other weren’t able to earn income. Some people have high enough incomes that having that amount of cash sitting around isn’t actually wise. Some people don’t feel comfortable once their bank account drops below a certain amount and it gives them anxiety. Some people have a business or a health problem that may warrant them keeping even more cash on hand.
It’s smart to have an emergency fund in place, but you should take your thinking beyond an estimate and figure out how much you really need.
Retirement Savings Rate
A lot of estimates that you see say that your retirement savings rate should be somewhere between 10% – 20%, depending on your age. Last year, Ben Carlson found that a college graduate starting at a $40K salary would need to begin saving 11.0% of his or her income at age 22 to have 2x their salary saved by age 35 (see the assumptions for his analysis here), which is a measure that a Fidelity study showed you would need to have saved to have 10x your income by age 67 (another rule of thumb, but this time backed up with some analysis).
A general retirement savings rate is tricky because everyone has different goals, different spending levels and ideas of retirement, and different thoughts of when they’d like to retire. I think many people underestimate how much of their own income they should be saving for retirement and a lot of people (especially young professionals) feel like it’s ok if they wait until later to start saving. When it comes to saving and investing money, the earlier the better. Regardless, these estimates are probably a good starting point and are likely more than most people are saving now.
Debt Payments
The typical debt ratios are misleading because they’re set so high that it would be difficult so save for retirement, save for short-term goals, and enjoy your life right now as well as make your debt payments if you were to max out these limits. The bank isn’t in the business of making sure you have a good cash flow plan in place and that you’re saving enough for retirement; they’re in the business of making sure they’ll get paid.
Front-End Debt-to-Income Ratio (Housing Expenses) = (Housing Expenses / Monthly Income) x 100
The typical front-end DTI that you see is that lenders want your monthly housing expenses to be a maximum of 28% of gross income, although some are more lenient and some are stricter. If 28% of your gross income (before any taxes or deductions have been taken out of your pay) is going towards housing costs, then you may have a hard time finding the money to reach your other goals.
Take your total income for the year, multiply it by .28, and then divide that number by 12. That’s how much would be going out each month towards housing costs with a 28% DTI ratio.
For example:
$50,000 Income x .28 Max DTI = $14,000 Housing Costs / 12 months = $1,166.67 monthly housing costs
Back-End Debt-to-Income Ratio (Housing Expenses + Other Debt) = (Total Monthly Debt Expense / Gross Monthly Income) x 100
If 36% of your gross income is going towards debt, then you’re probably going to have a hard time saving for your goals. That’s over 1/3 of your income going towards those payments.
For example:
$50,000 Income x .36 Max DTI = $18,000 Debt Expenses / 12 months = $1,500 monthly debt expenses
Life Insurance
A rule of thumb for life insurance is to have adeath benefit of 10-15x your earnings in coverage. This may be a good place to start, but there are so many factors that this generalization doesn’t take into consideration such as your time horizon, retirement date, goals, or anything else that could affect how much your family would need if something were to happen to you.
The goal is to become self-insured and not need any coverage, but not everyone is able to do so. Some people need more than 10x their income in life insurance coverage and some don’t need any coverage at all because their loved ones would be fine without the money. This is a highly subjective rule of thumb that requires a more detailed examination on an individual level.
Disability Insurance
A lack of proper disability insurance is one of the biggest holes in most people’s financial lives. Even those who have disability insurance coverage through their employer may not have proper coverage in place, but something is probably better than nothing. The rule of thumb that you often see for disability insurance is to have coverage that will replace 60% – 70% of your income.
If your employer pays for your disability insurance premiums, or if you pay for your employer-provided disability insurance coverage on a pre-tax basis, then the benefits would be taxable to you when you became disabled and received payments. The problem with this is that the policy may only cover 60% of your earnings if something were to happen to you and you couldn’t work. So, not only would you only receive 60% of your earnings, but they would also be taxed, further deceasing the % of your income you’d be replacing.
Another issue with many disability policies is that their definition of disability is “any occupation”. This means that if you’re disabled and can’t perform your own job, but you’re capable of performing another job even if it is well below your skill level and qualifications, the policy likely won’t pay. A more comprehensive (and more expensive) definition of disability is “own occupation”, meaning that the policy will pay benefits to you if you’re not able to perform your own job. Often policies are written with a modified own occupation definition where it may be an own occupation policy for a couple of years and then an any occupation policy after that.
Following a rule of thumb for disability insurance ignores too many significant details that could be extremely costly should you need to benefits in the future.
Your Life Isn’t A Rule of Thumb
Rule of thumb is defined by dictionary.com as “a general or approximate principle, procedure, or rule based on experience or practice, as opposed to a specific, scientific calculation or estimate.” They can be good measures to start with when becoming intentional, but they may not be right (sometimes not even close) for your financial situation. It’s important to understand that these are general guidelines and are not exact targets that everyone should be aiming for. It’s important to take a deeper dive into your personal situation to find out how these guidelines apply to you and how they need to be modified to help you achieve your goals.
