When it comes to personal finance, you’ve probably heard all types of “rules of thumb” to follow. Yet the painful truth is that there is no one-size-fits-all rulebook for financial success.
These rules are good places to start. However, blindly following them won’t lead to satisfying results. The future is unknown and every individual’s goals and circumstances are unique.
What you can do is use the rules as general guidance. Assess your goals and needs regularly, and adjust your strategies for saving, investing, spending and debt payment accordingly.
We’ve summarized 10 common personal finance rules that you can refer to but can feel free to pick and choose based on your own situation:
1. “Save 10% for retirement.”
If you are comfortable enough to start saving, a common rule of thumb is to save 10% of each paycheck for retirement.
Catherine Hawley, a San Francisco-based financial planner, told MagnifyMoney that 10% may too low a bar for many workers, especially those whose incomes may fluctuate.
“[This rule] might be better thought of as a starting place one builds on,” Hawley said. “If you have a high income but anticipate switching careers or if that income is not stable, such as some sales jobs, your long-term savings rate may need to be closer to 50% to keep you on track for retirement.”
By saving more now, you’re allowing yourself a cushion of protection if you were to see a major reduction income.
Another reason the 10% rule isn’t so great is that some people simply can’t afford to go there just yet. In that case, it’s much better to start with 4% or 5% and work your way up than let this rule dissuade you from saving at all.
Instead: If you are earning a lot, don’t let the rule stop you from saving more. If you are early in your career, you don’t have to get up to 10% all at once. At the very least, contribute enough to your company-sponsored retirement plan to capture the full company match, if you are offered one. From there, consider increasing your contribution based on your other financial goals.
2. “Whatever you do, max out your 401(k).”
Financial planners can’t emphasize enough the importance of saving for retirement: The earlier you start saving and the more you contribute, the better. But maxing out your 401(k) isn’t necessarily a good idea for everyone.
The legal maximum amount you can save in your 401(k) is $18,500 in 2018 ($24,500 if you are 50 or over). If you were starting from scratch, you would have to tuck away more than $1,500 a month to max it out by the year’s end.
If you are a high-wage earner, it’s great if you can max it out without much effort. But if you make $50,000 a year, you would have to stash nearly 40% of your salary for retirement. Remember, this is money that, if contributed to a traditional 401(k), can’t be withdrawn until age 59 1/2 without incurring penalties (with some exceptions).
Planning for retirement from an early age is wonderful, but there may be other goals you want to achieve when you are young and need money in the near future. For example, you might want to prioritize paying off high-interest debts like credit cards or auto debt before throwing a good chunk of your paycheck into your retirement fund. And you should definitely save up at least a few months’ worth of income in your savings account so you have money set aside in case of emergencies.
It’s not wise to sacrifice your current life goals if maxing out your 401(k) is a tough task.
Instead: Although there are multiple benefits to saving for retirement, you may want to take a holistic view of your financial situation and review your near-term financial goals before deciding whether or not to max out your 401(k). Read our guidelines on things you should consider before hitting that maximum.
3. “Save at least three to six months’ worth of expenses.”
One common financial planner mantra is that you should have an emergency fund to cover three to six months of expenses.
Clearly, not many people can achieve that goal. The Federal Reserve reported that in 2016, 44% of Americans could not come up with $400 in cash to cover emergencies.
Depending on circumstances, some people probably can make do with a smaller cash reserve, but others may need a bigger one.
Hawley suggested for those who have consumer debt, they may be better off having a smaller emergency fund while prioritizing paying off one’s deficit.
A person who has an unstable income or several mouths to feed may find that three to six months’ worth of expenses may not be nearly enough. For example, if you’re a freelancer or a seasonal worker, you may want to double your savings goal so you can cover any dry spells.
“If you are very conservative or in a volatile industry where you periodically get laid off you may be more comfortable with more cash on hand,” Hawley added.
Instead: An emergency fund is an account you can use to cover necessary expenses in case you lose a job, your car breaks down or you get hit by an unexpected hospital bill. Your non-routine costs like a vacation or a kitchen renovation should not be part of the calculation. Don’t be afraid to go below or beyond the three-to-six-month rule considering your needs and debt situation. In general, the less steady your job is and the more dependents you have, the larger your emergency fund should be.
4. “Subtract your age from 100 to get your perfect investment allocation.”
One of the most basic rules for asset allocation is to subtract your age from 100 to calculate the percentage of your portfolio that you should keep in stocks.
Under this rule, at age 25, for instance, you should keep 75% of your portfolio in stocks and the rest in bonds and other relatively safer securities. At age 75, you invest 25% of your assets in stocks. The idea is to gradually reduce investment risk as you age, because older people don’t have as much time to wait for a market bounce-back following a dip.
Much research has been done about asset allocation adjustment for retirement. Experts have different conclusions based on different models. David Blanchett, head of retirement research for Morningstar Investment Management, concluded in an 2015 article that declining shares in equity as people grow older is best for retirement planning in an environment of low bond yields and decent market performance.
This 100-minus-age rule is a good place to get people started in allocating their investments, but it has its flaws.
Americans are living longer and retiring later. The average life expectancy was 79 in 2015, five years longer than 1980, according to the World Bank. Retirement savings strategies should be adjusted as people need a bigger nest egg, can potentially grow the money more and recover from a market downturn.
At the same time, the yield on a 10-year Treasury Bill is roughly 2.5%, down from a peak of nearly 16% in the 1980s. But the stock market keeps soaring — the Dow Jones Industrial Average shot up 24% last year and hit 26,000 for the first time the third week of January. It may not make as much sense today to dump a large portion of money into fixed income when you could potentially reap greater gains.
Instead: Rebalance your investment portfolio each year, considering your target retirement age, plans on using the funds at retirement, your risk tolerance and market performance. If you’re feeling more comfortable with risk, use 110 (or even 120) as a starting point to calculate your stock exposure.
Maria Bruno, senior investment analyst at the Vanguard Investment Group, told MagnifyMoney that stocks should be a significant part of a young worker’s portfolio — 80-100% in equity is very reasonable. For people in retirement, it’s better to be more conservative but still not too afraid to take some risks. A ratio of 60:40 stocks to bonds is considered a balanced allocation for them, Bruno said.
“Equities still do play a role for somebody at retirement because they could be looking at a 30- to 35-year time horizon,” Bruno said. “Individuals may think that they are playing it safe by staying out of the market, but actually what they are doing is they are overexposing themselves to inflation risk, because the portofolio can’t grow in real terms.”
5. “Withdraw 4% of your savings in retirement.”
Here is another retirement savings regimen: You start withdrawing 4% from your portfolio in your first year of retirement, increasing your withdrawal each year enough to cover inflation.
If you have $1 million in your retirement account, for instance, you take out $40,000 for the first year. If the annual inflation rate is 2%, then you withdraw $40,800 the following year ($40,000 plus 2%). And you continue on the path for the next 30 years. This rule was created based on historical data by financial advisor William Bengen in 1994.
But this is not how life works; it hardly goes as planned. Your spending in retirement may vary year by year. This rigid rule doesn’t take into consideration of your investment performance, your retirement time horizon nor the current market and economic conditions. It assumes retirees have a portfolio split between stocks and bonds. Bengen later revised the rule himself to 4.5%, using a more diversified portfolio.
Instead: Be flexible. Revise your spending rate annually based on needs, portfolio performance and taxes. If you have a personal financial advisor, discuss with your planner to determine the withdrawal rates that best suit your personal situation.
For early retirees or someone who’s invested much more conservatively and may have a smaller nest egg, they would probably need to withdraw a little under 4% to make sure their lifestyle remains sustainable, Bruno said. On the other end, she said someone with a shorter horizon — in other words, someone who doesn’t think they’ll have much time to enjoy their savings — or who’s late in retirement shouldn’t feel tied to that 4% rule; instead, they could stand to spend a little bit more.
6. “Spend no more than 30% of your income on housing.”
The 30% rule is a common budget benchmark for housing costs. The idea is to cap your rent or mortgage at under 30% of your monthly income.
This idea stems from housing regulations from the late ’60s. A U.S. Census Bureau study said the Brooke Amendment (1969) to the 1968 Housing and Urban Development Act established the rent threshold of 25% of family income in response to rising renting costs. The rent standard later rose to 30% in 1981, which has since remained unchanged, according to the study.
But the standard crafted almost four decades ago may not be realistic for many today. A Harvard University study shows that in 2015, nearly 21 million renters — that’s nearly half of the country’s renters — spent more than 30% of their income on housing across the country.
Instead: Think of affordability instead of the 30% rule. Depending on how much you earn, how much debt you bear and where you live, rent could be more or less than 30% of your paycheck. Hawley said she encourages people to work on earning more when rent eats away a huge chunk of income, which may be easier than relocating to reduce rent. If you live in a relatively affordable area compared with California or New York, housing doesn’t have to fill 30% of the budget, she said. In that case, you may have wiggle room to save more.
7. “Buy in bulk.”
Price per unit may be cheaper at club warehouses like Costco than a local grocery store, and buying in bulk saves money for tens of thousands of American families. But bulk-buying won’t necessarily save money if you buy more than what you can consume. Indeed, many shoppers confessed they have always bought more than they needed just because they couldn’t avoid the temptation of “super deals” at those clubs.
In addition, wholesale markets are not a paradise for every family. If it’s a family of two, the quantities of groceries you stocked up from a major trip to a wholesale market are so large that it may take weeks or even months to consume. You are basically paying upfront a lot more for saving money later. Worse yet, jumbo-sized products may go rotten or expire before you remember that they are even there.
A 2014 University of Arizona study found that families trying to buy all their groceries in one major trip, stocking up on discounted items and purchasing in bulk often buy things that end up unused.
Instead: Buy what you need and how much you need now.
8. “Borrow as much student debt as your expected salary.”
Many college students find themselves saddled with an enormous student loan debt today.
When determining how much students should borrow for higher education, a rule of thumb is that you should cap your total student loan debt below your expected first-year annual salary.
But wait a minute, private schools charge far more than public universities. In some industries, wage growth has been in Stagnantville for decades. Graduates may see big wage increases as their careers advance if they are in finance or law. But if they are government workers, their pay raises may not come as often and substantial.
In a MagnifyMoney survey of the 2017 graduate class, 40% of the 1,000 surveyed recent graduates with student loans anticipated that they’d need more than 10 years to repay their student loans.
Aside from the projected initial annual salary, many other factors, including time expected to repay the loan, the school you attend, the industry you may end up entering, should go into the borrowing calculation.
Instead: Figure out how much you actually need to borrow by evaluating the potential costs, including tuitions, fees and living expenses. Adjust your lifestyle and cut down unnecessary expenses. Remember, you want to borrow as little as possible. Find a loan that works for your future lifestyle. Refinance student loans to a lower interest rate can help you save money.
9. “Pay off your mortgage before saving for retirement.”
You may be advised to pay off your mortgage as early as possible because debt is a liability. It may feel great to be completely debt-free, but slowly paying off your mortgage early isn’t always the best move, especially if you are not living in your home for the long run.
“If you can pay off the house you plan to stay in for five years or more after the debt is retired, great,” said Kristin C. Sullivan, a Denver, Co.-based financial planner. “If not, keep that money for yourself and invest more in your 401(k) or other assets that have the possibility for growth.”
Homeowners who purchased their homes after Dec. 15, 2017 can deduct mortgage interest paid on up to $750,000 in mortgage debt from their taxes under the new tax law. For those living in expensive housing markets who will itemize their taxes, that’s all the more reason to invest that money elsewhere.
Instead: Before adding extra monthly mortgage payment, you should pay off other high-interest debt first, such as credit card balance. Prioritize your financial goals, for example, ask yourself whether paying off the mortgage or investing for retirement is more important for you, or if you want to save for your children’s education. If you can enjoy the tax benefits or plan to move in the next five years, that money can be well used in other ways.
10. “Credit cards are bad.”
Many people shy away from credit cards, being fearful that they will spend money they don’t have and later be trapped in debt over their heads. Those people are more likely to rely on debit cards or cash.
But credit cards are not that bad at all if they are used wisely. A cardholder will stay out of trouble if he/she can pay off the balance on time and in full to avoid a high-interest charge.
By steering clear of credit cards, consumers not only miss the opportunity to build credit, but lose rewards, which can come in forms of travel points or cash, that credit card companies give to incentivize cardholders to spend.
Instead: Stick to your budget and spend within your means. Focus on your card balance — not your credit limit. Set auto payment to pay off your credit debt in full, not just the minimum balance, every month. Check our latest review of best credit card offers and how to choose a card that suits your needs.