Why We Love Rules of Thumb…Even Though They Suck
For a lot of us, when things get complicated and we have big decisions to make, we secretly want someone to just tell us what to do. I never liked when my parents did this when I was a kid, but now? Please do! Someone?.anyone? Help!
When it comes to career advice, sustainable living, or any other complicated situation, we want a simple, quick answer from a source we trust. Managing our money is no different. It can feel incredibly daunting to make decisions about our financial well-being, especially when making a mistake can cost us. So the answer to this dilemma?
Rules of thumb for common money woes (and when to bend them)
Rules of thumb are everywhere. They’re simple, tweetable, and make for great tidbits you can share at your next cocktail party to convince your friends you know what you’re talking about. (I’m guilty of using them myself.) But they can also be problematic: Rules of thumb, by definition, are one-size-fits-all that don’t leave much wiggle room. There will inevitably be situations when they just don’t quite fit. And there will be other situations when they are outright wrong.
Their other downside? Rules of thumb rarely directly address the real questions we have about money. Am I really ready to buy a house? Should my partner and I combine our finances? Can I afford to take a vacation? What would it mean to quit my job and go freelance? Most personal finance decisions are truly personal. It’s all about what’s right for you and your particular situation. No rule of thumb can answer that.
Rules of thumb rarely directly address the real questions we have about money.
So should we start ignoring these catchy rules? Not quite.
Here a few examples that truly are worth paying attention to and some ideas on when you might want to bend the rules:
Spend 50% of your income on needs (housing, bills, transportation to and from work), 30% on wants (dining out, shopping), and the remaining 20% on financial priorities (paying more towards your debt, starting an emergency fund, saving for long term goals).
When to bend the rule:
This is a neat little formula but many people may find that their current budget doesn’t fit into these boxes. Maybe you’re a new grad who moved to an expensive city and earn an entry level salary. Your needs would likely eat up far more than 50% of your budget. Maybe you’re planning to take a year long sabbatical to travel around the world. You may need to devote far more than 20% of your pay to this goal in order to make it happen.
If you don’t fit into this formula – it’s okay! Find your own balance that makes the most sense for you. Don’t feel guilty about making tradeoffs either. A cheaper apartment means more room for dinners out with friends. But for someone else who values nights at home in a comfortable living space far more, a higher rent may be just fine.
3-6 Month Emergency Fund:
Save the equivalent of 3-6 months of expenses in a savings account for emergencies.
When to bend the rule:
There are plenty of people who would sleep much better at night with 9 or even 12 months worth of spending money saved in their bank account. Some of them may have experienced a layoff followed by a long job hunt, others may have very lumpy income from freelancing gigs, and then there are those that are just plain conservative.
On the other hand, there are those who are more comfortable with taking on a little risk, some who need their extra cash to pay down high interest credit card debt, and some that have other safeguards in place like disability insurance, a high earning partner, or multiple passive income streams. These people may be comfortable with a much smaller emergency fund than most.
Think about your own personal situation and how much you would need to pay for an out of the ordinary medical bill, or to cover your expenses if you lost your job. No one can assign you the perfect number that would save you from any potential financial disaster. Always leave enough of a cash cushion to cover immediate needs in an emergency and have a plan for how you would cover extra costs should they come up.
20% Down on a Home:
Always put down at least 20% of the purchase price when buying a home.
When to bend the rule:
Coming up with a down payment is the biggest obstacle many people face when it comes to home ownership. A down payment of 20% has been the standard, however, it is in no way required, and for many it may be unrealistic. FHA loans require a down payment of at least 3.5%, some conventional loans require only 3%, and there are a number of other housing programs that require no down payment at all.
It’s important to know that a smaller down payment often comes with extra costs like a higher interest rate on your mortgage and private mortgage insurance. You will also have less equity in your home at first. On the flip side, less of a down payment means more money available to cover closing costs, pad your emergency fund, or invest for retirement. It can also mean you move into your dream home much sooner. The moral of the story here: there is no one right way to buy a house!
Rules of thumb can be a great jumping-off point for figuring our your finances, but ultimately the way you manage your money is up to you. There is no one-size-fits-all approach that’s going to work for every situation; so rather than try to conform to a rule of thumb, explore your options and decide what makes the most sense for you. Just because a simple rule won’t provide you with all the answers, don’t be intimidated to take action anyway. A dollar saved, paid towards debt, or invested is always better than nothing.
Photo by Scott WebbTags: budgeting, buying a home, emergency savings, hacks, high interest credit card debt, insurance, mortgage, private mortgage, rules, savings, tricks