Financial Rules that Work and Don't Work

If you read a handful of books (or read a few money sites or listen to a few financial radio shows) by today’s popular financial gurus, and you will begin to notice the same advice being given over and over again. The advice is designed for the masses and meant to offer general guidelines that work for most people. Yet, have you ever stopped to think whether the directions being given is actually good advice?  Here's my take on some of the most comment money suggestions given today:

• Save 10% of your income.  This is a good beginning point IMO. The 10-10-80 budget, which is what I consider to be a good guideline for those just starting to manage their finances, lists 10% savings as the goal. That said, the budget also assumes that the "10s" (saving and giving) will get larger over time and the "80" (spending will get smaller.) So for those just starting out, saving 10% of your income is good advice. But for those five years down the road or so there needs to be some progress to get that 10% moving up.


• Borrowing for good debt is okay (defining "good debt" as debt that allows you to ultimately earn more than the cost of the debt -- generally thought of as student loans and a mortgage.) I'm willing to concede that this is at least fair advice if done within reason. By "within reason" I mean that college debt needs to be aligned with expected post-graduate earnings and a mortgage needs to be taken out on a house you can afford. Furthermore, I prefer that people take out “good” debt for as little time as possible.  After all, debt, even good debt, is debt, which hurts cash flow and financial growth. This is why I paid off all my debt 15 years ago.


• Buy life insurance worth 10x your income.  Not good advice.  This is advice that many financial advisors give, but it is too simple to cover everyone’s unique situations.  Instead, I like this formula:

Total need - total liquid net worth + a bit of cushion = amount of life insurance needed.

Using this formula, I have taken out 5x my annual salary in life insurance.

• You’ll need 80% of your income in retirement. Not good advice. It's too general and is based on what you earn, not what you spend. I suggest you estimate what you think you'll spend in retirement by creating a mock budget. Adjust it every two or three years. Then save to cover those expenses plus a little bit extra. Oh, and don't forget to factor in the impact of inflation.


• Get the full employer match to your 401k.  Good advice. Why? It's FREE MONEY! And a lot of it to boot! If you average $50,000 per year over a 40-year career and get a 100% match on the first 3% you put into your plan, that's $60,000 in FREE MONEY before you add in any growth. In addition, it's a 100% return on your money. Investors are struggling to make 10% on a regular basis, so IMO, 100% is pretty good. ;-)


• Your total debt load shouldn’t exceed 36% of your income.  Good advice in general.  The only think I can add is that this 36% is the ceiling -- you should not be above it -- and the lower, the better IMO.


• Your home mortgage shouldn’t be more than 28% of your income.  Decent advice as long as it's combined with my thoughts above.  I would add that my preference is that you shouldn’t buy a house that costs more than 2 times your annual salary.


• When paying off debt, pay the debt with the highest interest rate first.  Good advice mathematically, but bad advice psychologically. I won't go over the reasons I used to think the "highest rate" option was better but have changed my mind over the years, but if you're interested in more details you can read What's the Best Way to Pay Off Credit Card Debt?

There you have it.  Eight common pieces of financial advice. What's your take on these? Do you agree with me on which rules offer good advice and which offer bad advice?

Comments

[Luis]

On the topic of paying high interest debt first, I hear this advice often or the pay the lowest debt first. I've never heard what is my advice, calculate the interest cost in dollars of each debt and pay the highest dollar amount.

[Rick Francis]

On the 10% rule- I calculated what % you need to invest to replace your income in retirement, in most cases 10% isn't enough. You need to both start early and get a good rate of return for 10% to be enough. A better alternative is to have a goal number then you can try to calculate how much you need to save to reach that goal.

-Rick Francis

[Daisy @ Add Vodka]

Interesting. I don't know much about life insurance, etc, but I do agree about employer retirement savings matching. It shocks me when people don't take advantage of it!

[MattJ]

Borrowing for good debt is okay

Everyone always talks about mortgages and colleges under this topic. Nobody ever says that business loans are good debt. All of the successful businessmen I know (except a possibly couple of them involved in very low-overhead businesses) got started with business loans.

Very good debt, if you have a workable business plan.

also, how about:

Your home mortgage -payments- shouldn’t be more than 28% of your income

Strictly speaking, the mortgage is the total amount owed.

Also, I was happy that after following the link you had previously said that the mortage shouldn't be more than two times your income. Of course you can get a house that's more than two times your income, provided you have the cash saved up to pay for it. (Some retired people may have little to no income at all - they can't buy houses?!)

[Jonathan]

"Your total debt load shouldn't exceed 36% of your income" - Is this the actual debt balance, or the combined minimum monthly payments? If it's actual debt then I assume this is exclusive of mortgages? If it's minimum payments, that makes more sense, but I don't know the significance of 36% unless it's for credit score purposes. In fact 36% seems pretty high to me.

[Elle]

Regarding paying off debt, a lot of the decision on what to pay off first is personal. Do you need to see results NOW (payoff lowest balance first)? I was introduced to powerpay.org in college as a tool to determine what debt to payoff first, high interest, low interest, high balance, low balance, how much total interest you'll pay, and how long it will take.

[FMF]

Jonathan --

Combined monthly payments. But personally I'd recommend an amount a lot lower than this.

[jim]

I generally agree with FMF on these.

I would say that I don't think shooting for 80% of your income during retirement is 'bad' advice exactly. Its not perfect for everyone, but I think 80% is a good figure to shoot for. Most people should really not need more than that so then more often if the number is wrong its too high which isn't really a bad thing to have too much retirement savings and overshoot your actual needs.

[Squeezer @Personal Finance Success]

You have a lot of good advice. However, I think most people can get a mortgage up to 2.5x their gross income. I would not go any more than that.

[Kelly@All-FinancialNews]

In terms of borrowing for good debt, this would apply for going back to school after a career is already established, because you may be able to plausibly determine what you will be making as an increase in new potential salary post-graduation, however for loans for students out of high school going into college, it's quite hard to predict the amount they'll make the years right after school. In addition, its hard to predict what the entire cost of their 4 (or more) years at a university will be taking into consideration housing options (on or off campus) dining services/meal plans, and other costs (text books, project expenses, etc.)

[Cathryn]

First thing, is I never carry credit card debt. Never have. Just a personal thing.
I agree with Luis on calculating the actual cost of interest if you have multiple credit card debt. However,
this issue would go away if you only had one rate on
all your cards. In some cases, is it possible to
negotiate the interest rate down, as well?
My mother never had credit card debt, then in 'helping friends' late in life did accomplish credit card debt.
The interest rate on her credit card was close to 30%
and it was replaced with a rate around 9% when she
called them. She trusted , and thought they
would automatically adjust the rate for current economic conditions.

[Frugal Portland]

Do single people need life insurance?

[Joseph M. Stevens]

Hello, this article about "financial rules that work and don't work" provides valuable information to consider to improve businesses and online payments procesing, thanks for all

[prufock]

For the Mortgage-to-Income ratio, does that assume 2x your gross or net income? Two very different numbers.

[FMF]

prufock --

Gross.

[K00kyKelly]

@Frugal Portland - single people may need life insurance if they have student loan debts. They can be passed onto your parents in many situations if you die.

I dissagree with the housing advice not to buy a home over 2x your salary. Like so many of the others, it depends. If you are in an expensive area this advice may not make sense. Instead consider the price to rent ratio (home price / yearly rent). Under 15x is a good rule of thumb.