Financial Rules of Thumb
From Jeremy Vohwinkle, former About.com Guide
Everyone has a unique situation, and there are no concrete financial numbers that define success, but there are some rules of thumb that can help you gauge your progress. While following these rules won’t guarantee success, they will put you on the right track.
How Much Debt Should You Have?
Ideally, no debt would be the best answer, but you have to realize that for some assets it is almost required you borrow money, such as buying a house. Most experts agree that your total monthly debt payments shouldn’t exceed 36% of your gross monthly income. This is a good starting point, and over time if you can reduce that number you’ll be in pretty good shape.
How Much Home Should You Buy?
You should start by calculating your debt-to-income ratio using the 36% guideline for the sum of your monthly debts. After subtracting your other debt, you are left with a monthly payment that should be appropriate.
Another rule of thumb for housing is that you should buy a house that costs no more than two and a half to three times your annual income. For example, if you and your spouse together earn $100,000 per year, you shouldn’t spend more than $250,000-$300,000 on a home.
How Much Money Should You Save?
One of the most widely used rules for saving is that you should save at least 10% of your income. Keep in mind, this is typically assuming you are saving additional money into a retirement plan as well. This 10% rule applies to creating a savings cushion for unexpected expenses, a college education, or other goals.
When it comes to how much you should save for retirement, if your company offers a matching program, you need to save at least enough to take advantage of that. It is free money. These matching programs can be anywhere from 3-5% of your gross pay, but your retirement savings shouldn’t stop there. Younger people who have more time to save should strive for a minimum of 10%, although the closer you are to retirement, you may be shooting for 20-30% depending on your current nest egg.
How Big Should Your Emergency Fund Be?
An emergency fund is used to cover expenses when there is a sudden loss of income or other financial emergency. Most experts suggest a household have between three and six months worth of expenses available in the event of an emergency. So, if your monthly obligations total $2,500, you should try and keep between $7,500 and $15,000 in your emergency fund.
How Much Money Will You Need in Retirement?
Many experts use the assumption that you will need to replace your pre-retirement income by 75-80%. So, if you make $80,000 the year before you retire, you should expect to have a little over $60,000 in income during retirement.
Another way to think about that is to use the lump-sum assumption which says your nest egg should be approximately 20 times your annual retirement expenses that aren’t covered by outside sources of income, such as social security or a pension.