A rule of thumb is not exact; it's intended to be what I would call "directionally correct." It's easy, quick and designed to keep you on track or out of trouble.
In this series, I'll provide some commentary on several common financial rules of thumb. Before I get started, let me share one of my own: Never use a rule of thumb as a proof point for a financial discussion with a submariner.
If you are a submariner -- anyone who is, let's say, a bit analytical -- rest easy. That was not an attack. When it comes to money, I think it makes a lot of sense to seek answers with more depth than a rule of thumb provides.
However, I also think having a plan -- even if a bit superficial -- is better than no plan at all. So, let's look at a few oft-used guidelines:
Rule of Thumb: Maintain an emergency fund equivalent to three to six months of expenses.
This is right out of a Financial Planning 101 course. An emergency fund is the foundational element of any financial plan. Money set aside for life's curveballs -- job loss, car or house repairs, medical emergency, etc. -- can keep you out of financial trouble. If you don't have a stash of cash, you may have to turn to credit cards, borrowing from family or friends, or selling stuff to respond to the setback.
It's hard to argue with the concept of maintaining an emergency fund. On the other hand, determining the "right" amount is a bit tricky. A host of factors could lead you away -- in either direction -- from the basic rule of thumb.
- Job/income security. The more uncertain your income, the larger you may want your emergency fund. Those with variable or seasonal income may prefer to have more cash on hand. Dual-income military families, where the non-military spouse's job is geographically based, may decide to boost their cash reserves to accommodate the inevitable income drop that will come with the next PCS move.
- Leaving the military. About a quarter of a million service members do it each year. At USAA, we recommend each one have up to a year's worth of expense money set aside to ease the financial burden of transition.
- Risk tolerance. It just makes sense that more conservative people would feel more comfortable with more cash. On the other hand, risk-takers might feel a pang of regret each time they check out their oversized bank account.
- Irregular expenses. The potential for nonrecurring expenses might lead you to keep more cash in reserve. For example, landlords may boost their savings above and beyond the rule of thumb to account for time periods without tenants or big-ticket repairs or maintenance. And people without a mortgage -- or people who don't escrow their real estate taxes, especially in a high-property tax state like Texas -- might set aside more.
On the whole, this is a solid rule of thumb. I recently read a Federal Reserve study that indicated 40% of Americans had less than $400 in savings. So, while there are plenty of good reasons to go above and beyond the three- to six-month benchmark, we'd all be better off if we just got there.