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Financial Strategies
How Useful Are Financial Rules of Thumb?
By Roger Wohlner
CERTIFIED FINANCIAL PLANNER™ Practioner, Asset Strategy Consultants
Financial rules of thumb are designed to give you quick guidelines for your finances. However, you shouldn't follow them without giving some thought to your personal circumstances. Some of the more common financial rules of thumb include:
Save 10% of your gross income.
While this will give you a good start, it's typically the minimum, not the maximum, you should be saving. Analyze how much you'll need for your financial goals, and then decide how much to save every year.
Plan on spending 80% of your preretirement income during retirement.
This may be true if you don't plan to be very active during retirement, but more and more people expect retirement to include extensive travel and expensive hobbies. On the other hand, if you've paid off your mortgage and your children have finished college, you may need less than this. Review your individual situation and desires for retirement to determine how much you'll need.
Set the percentage of stocks in your portfolio to 100 minus your age.
With increased life expectancies, this can result in your portfolio being too heavily weighted in income investments. Set your asset allocation based on your risk tolerance and time horizon for investing. Even after retirement, stocks may comprise a significant portion of your portfolio.
Keep three to six months of income in an emergency fund.
While an emergency fund is a good idea, how much to keep in that fund will depend on your circumstances. You may need a larger reserve if you are the sole wage earner in the family, work at a seasonal job, own your own company, or rely on commissions or bonuses. A smaller reserve may be required if you have more than one source of income, can borrow significant sums quickly, or carry insurance to cover many emergencies.
Pay no more than 20% of your take-home pay toward short-term debt.
Once considered a firm rule by lenders, you can obtain loans even if you exceed this amount. However, don't become complacent if you meet this rule of thumb, since a large percentage of your income is still going to pay debt. Try to reduce your debt, or at least reduce the interest rates on that debt.
Keep your mortgage or rent payment to no more than 30% of your gross income.
While you can obtain a mortgage for more than that, staying within this rule will help ensure you have money to devote to other financial goals.
Obtain life insurance equal to six times your annual income.
Different individuals require vastly different amounts of insurance, depending on whether one or both spouses work, whether minor children are part of the family, or whether insurance is being obtained for other needs, such as to fund a buy/sell agreement or to help pay estate taxes. Thus, you should determine your precise needs before purchasing insurance.
Most financial rules of thumb should not be followed without first considering your individual circumstances.
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