I was speaking with a young woman recently whose fear of her money was nearly incapacitating her, so we talked about breaking things down into more digestible rules of thumb rather than letting “the money issues” overwhelm her. In case anyone else has those same feelings, I thought I would share some of what we discussed, so here goes – A glove full of money-based Rules of Thumb.
Rule #1 – Work from a Cash Flow Plan. Yup, I’ll throw the ugly one out right at the top of the list. I can honestly say that the majority of the people through my door cringe at the very mention of budgeting. No, pleeeaaase don’t make me do it, they say. The truth of the matter is that a successful financial life hinges on a solid understanding of where you are spending your income. Remember, a cash flow plan isn’t punitive, it’s educational. Once you know where your dollars are going, you can make an educated decision about whether that expense is worth more or less than one of your goals, be it retirement, buying a new house / car / whatever, building a cash reserve, or taking a vacation. In our eyes, cash flow plans are no judgement zones – on the other hand, if you are feeling somewhat guilty about spending money on something, perhaps you should be listening to what your brain is trying to tell you.
Rule #2 – An Emergency Fund is your ticket to a good night’s sleep. The basic core of your emergency fund, also known as a cash reserve, should be at least three months of expenses broken down into 1 – 2 months at a local, bricks and mortar bank/credit union and at least another month either at that same location using a money market or in a cloud-based bank. Why 1 – 2 months of expenses locally? There are situations in life where cash is going to solve the problem at hand and an online bank isn’t going to meet your need. Three months, Kitty, really? How many months of expenses you should have set aside depends on your personal situation. Most of my nurses could leave their job on a Friday and be employed Monday morning (whether it’s a better job is a whole other question…). On the other hand, someone with a fairly specific skill set might need six months or more to land an appropriate job so their emergency fund should be more robust. Someone with strong short & long-term disability coverage won’t need as much as someone with the default New York State coverage (on which virtually no one can survive). How well does your cash reserve fit these criteria?
Rule #3 – If you can’t put 20% down on that new house, you shouldn’t be buying it. This one goes hand in hand with the adage that you shouldn’t be mortgaging more than 2.5 times your gross annual income. By spending some time saving for that larger down payment, you are putting some inherent guiderails on your everyday spending, which will help you throughout your financial life. By putting 20% down, you can also avoid the private mortgage insurance (PMI) which benefits the lender, not you. And, by having some equity built in from the get-go, you are less likely to end up underwater if the housing market cools, like, I don’t know, if the mortgage rates reach rates higher than they’ve been in the last 20 years. One quick check on whether you are overspending on a house – if you are married and one of you loses your job, can you still make the mortgage payments? Not sure? Head back up to Rule #1 and review how you are spending your income with a “worst case scenario” red pen.
Rule #4 – There is no Prince/Princess Charming so make sure you are saving for your own retirement. If you are single, and plan to remain that way, then this one is a bit of a no-brainer (although I’ve met a few people over the years who were banking on marrying well – to date, I don’t think any of them have). If you are in a relationship, making a point of checking to see if your own retirement is in good shape can be an enlightening experience and helpful if there needs to be some financial conversations between you and your partner. You should be saving at least 10-15% (if you’re younger) to 20% or more (if you’ve celebrated a few more birthdays and are late to the savings game) of your income into an account (or accounts) that are specifically earmarked for retirement and which you Do. Not. Touch. If you are a Stay-at-Home Spouse, you’ll want to make sure that your spouse is saving into an account in your name (using a Spousal IRA or Roth or an after-tax brokerage account). If your spouse says they have it all handled, ask for the reports and double check. The frightful truth is that many, many partners have no idea if they are saving enough and simply don’t want to find out the answer.
Rule #5 – With regards to those investment accounts, there are plenty of formulas to help you allocate your dollars. A popular one is the 60% / 40% rule with 60% being the stock exposure and 40% being the bond exposure. Personally, I think that this is a little simplistic but it’s a good place to start. That’s a moderate allocation. If, when you look in the mirror and have an honest conversation with yourself, you find that you are a more conservative person, then move some of that 60% over to the 40% side and target something closer to a 50% / 50% allocation. Feeling a little more aggressive? Swap things the other way. Another rule is the 20 / 2 rule – no one holding should represent more than 20% of your portfolio or less than 2%. Then there’s the 5% rule that says no one individual stock should represent more than 5% of your total portfolio – looking at you all you Apple, Amazon, or Microsoft stockholders out there. When you are calculating that 5%, don’t forget to include what is being held in the various mutual funds or ETFs that you hold.
And Rule #6 for those Princess Bride fans out there – There is good debt and there is bad debt. There are some “financial advisors” out there who preach that you shouldn’t carry any debt at all, and I think that’s a bit draconian. The right size mortgage is perfectly fine if it allows you to live in a better school district. A small car loan is perfectly fine if it allows you to have reliable transportation to your employment (which generates the money to pay for your loan and save for retirement). On the other hand (with its own set of thumbs for another day), charging a family trip to [insert destination here] when you don’t have the savings to pay the bill in full (or two payments) is bad debt. Taking out small annual student loans while earning a degree that is going to allow you to find solid employment can actually improve a student’s long-term financial health by establishing some good budgeting skills when it comes time to make those payments. Taking out large loans without a strong strategy of repaying them is just a recipe for years of financial stress, which doesn’t help anyone. The strategy here is to evaluate the considered debt and make sure there are positive benefits before taking on that payment.
There you go – 5 (well, 6) simple rules to create a solid and healthy financial life. Take a few moments this weekend and see how many thumbs you have in your financial glove.