In these recessionary times, financial tips are flowing fast and furious about how to save money and stick to a budget. Facing a sea of information many people are asking, “Where do I start?” For most of us, five areas of spending will consume over 50% of the money we earn during our lifetime, so that’s the best place to begin. The five areas are: Home, Car, Kids, Education, and Retirement. Here’s what you need to know about each:
- Don’t bite off more HOME than you can chew. How much house can you comfortably afford? For most people the answer is a house with a purchase price of no more than 3x their annual household income. Rationale: the cost of a home includes much more than the monthly mortgage payment. It’s also property tax, insurance, upkeep, etc. Typically these costs run 2%-3% of the price of your home each year. Assuming a 20% down payment, a 30-year fixed rate mortgage, and interests rates in the 5%-6% rate, the 3x your income rule of thumb will translate into total housing costs of roughly 30% of your gross income.
- Don’t let your CAR drive you to the poor house. The same logic applies to your car. Most people can comfortably afford a car that is 1/3rd of their annual income. If you make $60,000 you can comfortably afford a car that costs $20,000. If that seems low – now you know why so many Americans are in financial trouble. They are driving it. A car has many other costs than simply the monthly payment. There’s insurance, gas, parking, maintenance, etc. If you follow this rule of thumb, your total transportation costs should be 10% or less of your gross income.
- Don’t let your KIDS kick you in the wallet. Kids are expensive. From a purely clinical standpoint the Dept. of Agriculture estimates it will cost $220,000 to raise a child born in 2008 from diapers to age 18. And that figure is before you add in the cost of college! Deciding to be a parent is a major financial obligation. Don’t make it worse by over-indulging your love bundles.
- Don’t forget to ask “How high is too high for higher EDUCATION?” It used to be good debt was defined as mortgage and student loan debt… and bad debt was everything else. Not any more. We’ve now learned that too much of a good thing can indeed be bad. Rough rule of thumb, don’t take on more in total education debt than you think you are going to earn on average annually during your first 10 years after graduating (from college or grad school). In plain English, if you think you’ll make $50,000 a year, don’t take out more than $50,000 in loans. The logic behind this is that if it takes you more than 10 years of paying 10% of your income a year in student loan repayments, it’s going to be tough to meet your other financial obligations.
- Don’t underestimate the need to feed your RETIREMENT nest egg. How much will you need to retire? A simple rule of thumb is to multiply your current income by 25. So if you make $50,000 a year and want to maintain that standard of living in retirement, you’ll need a nest egg of at least $1,250,000. Understanding early on in your working life what “your number” is… will help you see just how important it is to plan for this major savings goal.
Thanks so much for this post, Manisha! I appreciate how straightforward you make everything.
Suzanne – So glad you found this post helpful. There are so many nuances you could add into any one of these calculations. For instance you could do reams of spreadsheets to figure out how much house you could afford – and maybe the “right” answer will turn out to be 3.2x your income or 2.8x your income. But I believe you’ll get 99% of the “right answer” from keeping it just this this simple. If people follow just these 5 rules of thumb, they’ll avoid most of the common financial pitfalls.
Hey, if they left scotch out not sure I trust the analysis 🙂
Dan – Well, I just saw a few tweets suggesting that healthcare / eldercare should have been on that list. We could put “medicinal” scotch in that bucket!
On a serious note, I totally concur that healthcare is conspicuous in its absence from my list – the tough issue was what rule of thumb to use. Depending on what type of insurance plan you have (if any) the bite that healthcare can / will take out of your income varies dramatically. So fingers crossed as a nation we can come up with some type of solution that the vast majority of people feel good about. I’ve got to believe Republicans & Democrats can find some common ground on this issue 🙂
I disagree with your last “rule of thumb” (that your “nest egg” should be 25X your income). The correct rule of thumb is actually 25X your income LESS other income sources in retirement (such as social security and pensions). For example, let’s say you make $120K/year the year before you retire, and you want to maintain that level of consumption in retirement. Once retired, you and your spouse will draw $40K/year in Social Security and $20K/year in pension income, with both the SS and pension COLA adjusted each year. Your nest egg needs to be 25X $60K, not $120K. This, by the way, is just the flip side of the 4% Safe Withdrawal Rate “rule of thumb”.
John – You are absolutely correct. Technically, the complete equation for calculating your necessary retirement nest egg is indeed the one you delineated. For readers who are interested in learning more about what John is talking about, I recommend reading Terry Savage’s book The Savage Number or spending some time poking around The Retire Early Home Page. The reason I opted for this more simplistic calculation of 25x your annual income was two fold: (1) To get people who may not find personal finance as fascinating as John & I do to grasp the enormity of the nest egg they’d need to maintain their standard of living. I can’t tell you how many people I’ve meet – nearing traditional retirement age – who currently spend well into the six-figures each year and yet have less than $100,000 in retirement saving. Often they have vague notions that Social Security will bail them out… and resist the notion that they must dramatically increasing their savings rate to maintain their standard of living, and (2) Many of my readers are in their 20s, 30s, and 40s… and with the massive deficits we are running a country and the virtual elimination of “old-styled” defined benefit pension plans (in favor of 401k type defined contribution plans) I think it’s prudent to err on the side of considering any Social Security payments 30 year down the road a delightful upside surprise. Thanks again, John, for sharing your wisdom, you are spot on!
This is a very unique and big-picture angle of looking at your personal finances that I think is very useful. We spend so much time in the day-to-day trenches, trying to figure out how to slash 20% off our insurance bill, or pay less for milk at one store versus the other.
Meanwhile, we forget about the major decisions in our life. They’re so overwhelming sometimes that we’re willing to just trust our gut and “go with it,” rather than making an objective analysis of how it will affect our life and our money.
So glad you found this post of help – I’m a big fan of the 80/20 principal (one of my all time favorite books is “Living the 80/20 Way” by Richard Koch). Seems to me when it comes to financial matters the general consensus is that complex is good… when more often than not it’s the reverse. I’d guesstimate that in over 2/3rds of the cases where I meet people who are in financial distress, if they had used this simple framework… the odds are high they would have avoided their financial wrong turn.
I truly loved this brilliant article. Please continue this awesome work. Regards, Duyq.
helpful post.
So glad you found the post useful – will try to keep helpful content coming. Thanks so much for visiting!
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