How Rules of Thumb May (or May Not) Work for You

Financial rules of thumb offer broad, simple guidelines that help consumers save, spend, and invest their money. While these rules are a useful starting point for many, they may only apply to some financial situations.

How can you tell when to follow one of these financial "rules" and when to seek more information or take a different path? Let's examine a few common rules of thumb and evaluate their relevance. As we'll learn, thinking critically about financial advice is essential.

Rule 1: Your Home Should Cost 2 ½ Times Your Annual Income?

This rule of thumb and its relevance depends heavily on where you live and current interest rates. Both interest rates and taxes will impact the monthly cost of your home. For example, a $300,000 home in New Jersey could have annual taxes of about $12,000 – or $1,000 per month. Contrast this figure with a similar home in South Carolina; the same $300,000 home will cost about $1,500 yearly in taxes in most counties. While both houses have the same ticket price, the actual monthly cost and affordability are significantly impacted by taxation.

Additionally, this rule doesn't account for variations in down payment amounts or the length of the mortgage term. A larger down payment or longer mortgage term could make a more expensive home more affordable. Conversely, a smaller down payment or shorter mortgage term could make a home that's 2 ½ times your annual income less affordable (a mortgage with a shorter term will cost less overall, but the monthly payments will be higher).

Rule 2: A Huge Emergency Fund Is a Must?

Emergencies happen, and having some savings set aside can make it much easier for you to deal with unexpected expenses. Whether it is a damaged car engine, broken refrigerator, or overflowing sink, having money to deal with an issue without taking on unplanned debt eases stress and helps keep your finances on track.

Some financial experts recommend saving anywhere from 3-6 months of living expenses in an emergency fund. Really?

While everyone needs an emergency fund, the size of it can vary. Choose how much you'll need on hand based on your life circumstances and the emergencies you may encounter. An emergency fund of even $1,000 or $2,000 would cover many car repairs and is enough to replace many major appliances - an excellent place to start. Increase your savings as you can, with the goal of an emergency fund that could cover several months of expenses in the event of a loss of income.

However, this larger cushion can provide peace of mind in case of job loss or extended illness. The right amount for your emergency fund will depend on factors like job security, health, and whether you have dependents.

Rule 3: Save 10% of Your Income for Retirement?

While saving 10% of your income for retirement is a good starting point, most experts believe saving more if possible, especially if you have disposable income, have started saving for retirement later in life, have a disabled dependent, or have other circumstances that could impact the amount of money you'll need in retirement. If you can only scrape together 10%, that's a great starting point. However, aiming higher, like 15-20%, will go a long way toward building a more substantial nest egg and comfortable retirement.

It's also important to consider the impact of compound interest. The earlier you start saving, the more time your money has to grow. So, even if you can only save a small amount when you're young, it can make a big difference.

Rule 4: Never Cosign on a Loan?

Most experts suggest avoiding cosigning on a loan to protect your social and family connections, not to mention your financial health. Anyone close enough to you to ask you to cosign is someone you risk losing if things go wrong. Would you feel comfortable sitting across the Thanksgiving table from your in-laws after they defaulted on a loan you cosigned?

However, there may be situations where cosigning makes sense, like helping a child establish credit or assisting an elderly parent. In these cases, it's important to have open, honest conversations about expectations and responsibilities. You should only cosign if you're willing and able to take on the debt yourself if the primary borrower can't pay.

The Takeaway

Learning more about financial rules of thumb – and when to take them with a grain of salt – can help you make the most of your income and savings. For best results, consider these "rules" as guidelines. Make sure they truly suit your financial situation before making significant changes. If you have questions about your financial plan, consider consulting with a financial professional to develop a personalized roadmap for your unique situation.