I often get asked quick questions such as “how much house can I afford?” or “how much life insurance do I need?” Personal finance is a very subjective science and the answers can vary widely depending on who is doing the asking. That said, it’s nice to have some basic rules of thumb which can be used to make sure you’re not totally off base when making a quick financial estimate. Below are a few of these rules which apply to saving, spending, housing, and insurance. Enjoy!
Saving: How much money should I be saving each year? You should be saving, on average, 10% of your gross household income every year. If you and your spouse have $100,000 in total income, $10,000 of that should be deferred into pre-tax and after-tax accounts. That percentage may be slightly lower if you start in your 20′s and slightly higher if you start in your mid-late 30′s. I emphasize “pre-tax” and “after-tax” because doing all of one or the other usually isn’t best.
Spending: What percentage of my income should I spend on housing? What about food and transportation? Here are some basic ratios for your household budget: a housing payment should be up to 25% of your gross income. That means your rent or your mortgage + taxes shouldn’t exceed 25% of your gross income. On a net (after-tax) basis this figure can be up to 33%. If you’re spending 40% of your income on housing, you’re almost definitely falling short in other places. On food, try 8% of your gross income or 10% of your after-tax income and yes, that includes going out to eat and groceries. Many of my clients who budget out spending for a few months notice they are more in the 12-15% per month on food range which is too high. For transportation, 6% should be your target number.
Housing: How much should I spend on my home? Your home should cost between 2 and 3 times your annual household income. In a low interest rate environment, you can be closer to 3x and in a rising or high interest rate environment, you should be closer to 2x. This rule of thumb will keep your mortgage where it should be and hopefully your taxes as well. If you’re earning $200K and buying a $1M house, you’re probably biting off more than you can chew, especially if you’re financing 80% of your purchase.
Life Insurance: How much life insurance do you need? 10x your income is the rule of thumb I like to use. If you earn $100,000, buy a minimum 1M policy. For some people who have several kids and higher costs of living, you may want to insure up to 20x your annual income. This rule of thumb is to make sure you aren’t dramatically underinsured. Check with your employer to see if you and your spouse receive any sort of life insurance benefit in the event of sudden death. Some employers provide a very basic benefit while others provide none at all. If you have kids or even a mortgage, you should look into what your insurance needs may be.
Emergency Fund: How big should your emergency fund be? An emergency fund is the amount you should keep on hand in the event of unexpected job loss, family emergency, or some other period of immediate financial need. You’ll see financial planners throw out numbers ranging from 3 months to 12 months to keep on hand as an emergency fund. I’ve found 4 months to be a good number. I’m fine with that emergency fund being held in bank accounts or brokerage accounts (after-tax) so long as they can be accessed within 1-2 days. I’ve found keeping more than 6 months on hand can become unproductive due to the missed opportunity of having those funds working for you in any number of other ways.
For Retirement: How much do you need to save to retire? Try 20x your annual spending. If you and your spouse currently need $150,000 per year to live comfortably, hopefully you can amass $3M in savings. That figure assumes 80% of pre-retirement income will be needed during retirement and that you withdraw from your portfolio at 4% per year. This rule of thumb obviously changes significantly if you have a pension or some other fixed source of income which may create less of a lump sum need.
Hopefully these figures give you a jump start into creating a healthy financial plan. Many people save too little and spend too much because the pressure is on to have nice things and keep up with neighbors and friends. I encourage you not to fall into this trap and instead focus on good relationships and activities you enjoy.
As always, feel free to reach me with any questions or concerns.
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