5 Money Ratios to Live By

By Carlos Portocarrero on 31 March 2010 (Updated 31 March 2011) 19 comments
Photo: Waifer X

Money is tough: we all want more of it but we all feel a little unsure of how we're supposed to handle it once we get it. Enter the handy-dandy financial ratio: it does all the work for us and spits out a nice, round number that all we have to do is follow. Let's take a look at five popular money ratios and see which ones are worth buying into and which ones are total bunk:

Spend 30% of Your Income on Housing

This one comes straight from the U.S. Department of Housing and Urban Development. According to them:

The generally accepted definition of affordability is for a household to pay no more than 30 percent of its annual income on housing.

This is a good one: it will keep you in line and make sure you don't run out of money when it comes to buying groceries, paying bills, and generally living your life.

Save 10% of Your Paycheck

You'll hear different numbers here, but the important thing is to save something — anything — right off the top of your paycheck. People just starting out in the workplace will think 10% is too high, and it probably is. But as long as you're saving something every paycheck then you're doing well.

As your salary grows you'll be able to grow this number more and more. But give yourself a cushion right from the start — it'll pay off down the line.

Spend Three Months Salary on an Engagement Ring

One of my best friends told me about this one before I knew it was common advice. And this one is total crap: it preys on the fear and ignorance of guys (like myself at that time) that don't know how much they're supposed to spend on a ring. Why is it crap? Because it was started by DeBeers, the very company trying to sell you the diamond ring. How do I know it's true? I saw it on Wikipedia and everything on there is true.

The right number is unique to each person and their situation. Maybe your girlfriend doesn't care that much about this or maybe she really does. The range of possibilities is too wide to create one number that we can all go by.

Don't Spend More than 4% of Your Nest Egg

This one was filed under "conventional wisdom" until a few years ago. Right next to "you can retire when you're 65." Now with the collapse of the stock market, retirees are re-evaluating all the advice they've been hearing throughout their lives. This number might stay relatively steady, but you may have to push retirement back a few years (or permanently in some cases).

This one is similar to the saving 10% of your paycheck: as long as you're aware that the amount you're taking out of your retirement account isn't too much and that you'll have some left in the future, then you should be fine.

120 - Your Age = How Much You Should Invest in Stocks

Some people say it should be 100 - your age and some say 120. The idea is to get a nice, easy percentage so you know how much you should be in stocks and how much in bonds. I am 29 right now and I'm 100% in stocks, so that tells you that I'm very aggressive.

If you're aggressive like me, you'll want to use the 120 number. The older you get, the more you want to be in bonds so you're better protected from the gyrations of the market.

One More Thing

These numbers are handy, you can't deny that. But don't live your life by them — each person's situation is unique and you shouldn't live your life (or not live it) based on these ratios. Nobody is perfect. Keep them in mind and make sure you're going to be OK in the short and long term. And then go out there and live.

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Guest's picture
Guy G.

Hey,
In The Wealthy Barber,
Michael Chilton said to save at least 10% of
whatever you earn and you probaly won't even notice it.
It's true that people just starting out might need to impliment
more tips on budgeting to be able to accomplish this, and reduce spending in other areas, but it can be done.

Cheers,

Guest's picture

Now, I realize that 10% isn't possible for everyone. People can get into all kinds of financial situations where it just isn't possible to do that.

That said, I advocate getting oneself to a point where it is possible to save beyond 10% - and well beyond. It may take time to get there, but saving 25% or more would be much better.

Just think about it - how do you replace this income when you need to retire? In an era of no pension funds, there won't be anyone to take care of you. Sure, some people will inherit assets and that could help those folks. But taking that out of the mix, it is imperative for people to save on their own.

Here is an example: A person making $50,000, saving 10%, will be saving $5,000 per year. Now just how far will that $5,000 go toward paying your bills when older? Well, if invested well it could earn a rate of return that outpaces inflation, while factoring in tax conseuqences, and compounding will fuel this growth. But even if your rate of return after taxes exceeded inflation by 2%, in today's purchasing power you would have a little over $8000 after 25 years. Think about it - if your after-tax rate of return is 5% and inflation is 3% (reasonable assumptions), that's what you get. One year of work will pay your bills for THAT year and, on a stand alone basis, will provide for about 2 months of living expenses in 25 years.

Better to save as much as you can, as early as you can. And keep that career going strong while living within your means.

Guest's picture
Q

You know, I actually found it easier to meet this savings goal when I was younger and didn't have house & family! I had my direct deposit set up so that money went directly into savings - I never saw, never had to do anything. Since I wasn't making all that much money, 10% of it didn't seem that huge, either, but it adds up quickly when you really do it every month.

Guest's picture
dave

Live on 50% of what you earn. Follow this and the rest takes care of itself.

Guest's picture
Anthony

These aren't technically ratios...!

You know people always talk poorly about these financial "rules-of-thumb". But if I generally took these rules as advice and implement them (except for the engagement ring one), I would be better off than most Americans.

Carlos Portocarrero's picture

Living on 50% of what you earn sounds great in theory dave, but realistically there aren't many people that can do it. Especially since they're struggling with living off 100% already.

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Guest's picture
Guest

I don't think so if you buckle down and get smart with your finances. My wife and I live on 50%, invest 25% toward retirement, and save the other 25% in cash for non-retirement investments. You just have to make the right choices and get things in check to live this way. I know it may be hard for some, but for those of us who do it, it's a great way to live!

Guest's picture
C. Holland

I agree that living on 50% of income a great way to live -- the problem for most people is getting there, which usually translates to getting out of debt. So let's talk about how to get rid of debt:

(1) Tackle debt the slow and hard way by systematically getting rid of it with frugal choices -- make this #1, work at it with intensity, & be willing to make some sacrifices (hard, but not necessarily permanent choices) to get there: Maybe I can't go 5 years without replacing the doggy old slow computer that is still limping along, but if it means getting the car payment off my back 2 to 6 months earlier, I can wait another 6-18 months. I'm re-framing my sacrifice so that I can see to the end of getting the car paid off and getting a new computer instead of thinking of it as being stuck with the doggy computer "practically forever".

(2) Even if Dave Ramsey's persona or politics make you cringe (I cringe!), he's right about the car, the garage/Craig's List/whatever sale, and the second job. These are all things that you can do to bomb debt. The pain they impose is temporary -- like the burn you feel while you peddle your bike up a steep hill -- and SOOO worth it when you are over the hump and on the downhill coast. My father was a big believer in letting someone else take the first few years of depreciation on a car and we've been paying cash for used cars for about 15 years now, driving each for 7 years or more -- your starter car on this system might be a junker that you only drive for a year or two so that you can put aside enough to get something better, but once you get this snowball rolling, the thousands in savings mount up very quickly.

(3) Buy as little house as you can make work. Don't put lots of expensive square footage on credit -- a.k.a. "a mortgage". Consider the return on sweat equity. For example, get less house but with a basement, attic, or garage that equals expansion potential and wait until you can dribble cash into it -- even if you are paying someone else to do the work. The pain of dribbling will serve as a further disincentive to overbuying.

If you have a big house, make it smaller. If you have more home than you need and are not ready to sell, consider whether your home is one that could be rented while you lived someplace cheaper. Consider opening a larger home to a renter or a family member who can help foot the bills (Phil Brewer writes about this).

(4) Keep paying off the mortgage on the radar. Consider how much closer to saving 50% you would be without a house payment. Figure out how little the mortgage income tax deduction is really worth (it's not the amount of interest v.s. principle that you shell out each month, but a percentage of it -- compare that actual number to the number you are actually shelling out each month -- yes, the deduction helps, but how many bucks are you spending to save a nickle?) Consider a 15 year fixed rate mortgage. Consider paying a 30 year mortgage like it's a 15 year mortgage. Consider putting any windfall money on the house.

Personal story: Back in the day, worked for a computer company that gave me stock options -- listened to the pie-in-the-sky "we'll go public & all be millionaires" talk & said to myself, if I can just make enough to pay off a house some day, I'll be happy. Exercised options when left company. 15 years after getting first "potentially valuable" (but for 15 years never worth anything because there was no market for it) option, the company was sold. Paid off house on proceeds (had in the meantime bought a modest house & expanded as we had the money). Windfall alone was not what got us there -- had been whittling at that 30 year mortgage as if it was a 15 year mortgage -- and had about 50% of the original loan amt to go when we got our windfall.

The best part came when my husband was laid off in December of 2008. Worst economic situation & real estate markets this country had seen in our lifetimes and we did not have to worry about losing the house. We sweated the COBRA payment, but we are not on the lists of foreclosed. Note that our strategy was not to "cash out on our stock" but to get out from under the house as soon as we could and we used multiple strategies to get there. We kept paying the house off on the radar.

(And, after a 9 month hiatus, my husband is now working, with health insurance, again.)

5) You can actually enjoy getting there! We've felt tremendous satisfaction as we've shed each millstone. Don't minimize this -- revel in it & use it to fuel you to tackle the next peak!

Our most recent millstone? Some "convenience" credit card debt my husband incurred prior to the job loss (it was so easy to whip out the card since there wasn't enough in the billfold, and anyway, we had the money in the bank...). I've been going cardless for well over 2 years now (one lapse burned my fingers) and I think this episode has convinced my husband to do the same. He put all the credit cards next to my debit cards in the safe deposit box over the weekend.

We have just become 100% debt free and it has freed up 50% of our income for savings. It can be done!

P.S. I recognize that our access to health insurance has been a critical support for us in our modest "success story", and I pray that we as a nation will embrace those changes in the structure of the health care system that have the potential to wipe out health care crises as a cause of economic devastation for American families. I speak here as a sister who has seen a health care crisis destroy the finances of her brother's family. With gratitude for being out of the hole & able to help again . . .

Guest's picture

"I don't think so if you buckle down and get smart with your finances. My wife and I live on 50%, invest 25% toward retirement, and save the other 25% in cash for non-retirement investments. You just have to make the right choices and get things in check to live this way. I know it may be hard for some, but for those of us who do it, it's a great way to live!"

This assumes that you have an income that allows you to live on 50% of your income in reasonable comfort. I'm not even talking about debt or luxuries like running water, electricity, or a vehicle with which to get to work. Not everyone is in that position, not by a long shot.

It's a great idea, but one that comes out of a place of privilege. It's not just about "buckling down and making smart choices." It's also about having the opportunity to live in a part of the world where you can get the kind of job that allows you to live well above the
poverty line so that you have the chance to make choices, where the choice is "do we live on 50% of our income or spend lavishly?" rather than "do I buy food or medicine for my sick child?" Most of the world lives in a financial condition where the second choice hits closer to home.

I will agree that it sounds like a great way to live, always having enough of the necessities of life paid for with so much room to spare.

Guest's picture
Guest

With respect to the 30% housing ratio...housing expense includes mortgage, insurance, property taxes, HOA dues and maintenance (2-3% of value of home for yearly maintenance is a rule of thumb I've seen). Obviously, if you rent, include renter's insurance.

Xin Lu's picture
Xin Lu

I think spending 30% of income on housing is way too much, especially if you mean 30% of gross income.  The engagement ring rule is silly, and kind of crazy.  As to the stocks rule, I think that's also too general since there are many types of stocks.  Some are "safer" than others.  Anyway, I guess the point of this article is that these rules aren't really set in stone.   

Guest's picture
cm

To give a number like 10% for how much one should save for retirement is dangerous. For those who don't earn enough or start early enough,

10% * Salary * Years Left << How Much They Need to Retire.

Instead, working backward from How Much You Need to Retire and then coming up with an *absolute value* for annual saving, instead of a relative one (that is, a percentage of earnings), is more apt. And for most people, that number should be about the same (say, $20,000/year per person). Often that absolute value will be more than one *can* save, even with cutting costs, and so it should motivate the person to try to earn much more than they currently are earning.

Guest's picture
Sam

I can never hit 10% - my govt job takes 15% out for the retirement fund.
It was 8% but apparently they invested it in the stock market and lost a bunch of it in 2008.... I wish there was a way to get out of the retirement because, I otherwise totally love my job, it the best job on earth for my family (single parent).
It has to be illegal to mandatorally take money like that, retirement should be voluntary, it is my responsibility to make sure I have enough when I retire - I don't make much to begin with & it really hurts. I've met with multiple financial planners who have told me that's the main ding in my money. I have some debt due to a long layoff before I got this job & the debt would have been paid off in months, not years if not for the retirement fund.
At least a 401k you can borrow against in a pinch and a Roth you can withdraw your contributions..... I can't touch that money with a 100ft pole & it's still counted as part of my salary (thus disqualifying us for some financial help at times).

BTW - because of the volume of people pulling from the retirement fund and the volume anticipated to retire I will never see any of my money unless I leave before I have 10 yrs tenure. If I leave before 10 yrs then I can petition to get my money back with no interest which it better then nothing. And at least then I can invest it how I see fit and actually have it if/when I retire.

C. Holland - your full of smoke on health care.
The real problem is Americans don't take care of themselves and over time their body starts to react to the chemical & fat laden food & lack of overall care.
You want to the see the "health crisis" go away? Then ban fried food (or at least hydrogenated fats), high fructose corn syrup (look up what it does to your internal organs)and any chemical made in a lab that's currently put into food and peoples healthcare expenses will plummet as their bodies get better.

I have health insurance however, due to all the people getting diabetic, having heart and other weight related health issues my insurance covers hardly anything. If my family took drugs then it'd be great because of the deals the insurance has with the drug companies but for getting the kids stitches & bones set it's worthless. My kid was in an accident in January and the insurance covered 10% leaving me with medical bills totaling over half my salary even though I pay the mandatory health insurance premiums. And the health care bill does nothing to address that. It is actually a sick care bill - they look to treat the symptoms not the actual cause of the symptoms.

Guest's picture
C. Holland

Sam -- couldn't agree with you more r.e. the following:

Ban fried food (or at least hydrogenated fats), high fructose corn syrup (look up what it does to your internal organs)and any chemical made in a lab that's currently put into food and peoples health care expenses will plummet as their bodies get better.

I

Guest's picture
Guest

Well, saving 10% while at the same time paying 21% on a credit card is good?

Let's make this easy:

http://www.daveramsey.com/new/baby-steps/

 

Guest's picture
c

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Guest's picture

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Guest's picture
David W

How am I supposed to invest 102% in stocks? (Im 18).

Guest's picture
PurchaseWisely

I have an issue with the 30% rule on housing. If you live in a decent (burglar bars not a necessity) area in Southern California, it's almost impossible to purchase a home on one salary if you stick to this rule. Unless you are very well paid it's impossible here, especially if you are single. Since detached homes are now built at about a minimum of 1,400 square feet, and all the older, smaller homes are being torn down to build new ones out to the lot lines, you can't purchase something smaller to keep down the cost. Please do note that I'm talking about a detached house, not a condo. I owned a condo for 8 years and do not ever want to consider living with shared walls and overly-restrictive homeowners' associations again!

I was fortunately able to purchase a home 12 years ago with 20% down (avoided PMI) and between insurance, taxes and mortgage it's still close to 40% of my income, and I didn't include cost of upkeep since I do most of the work myself - I'll be rebuilding part of my patio cover this weekend. Since I planned ahead and have no other debt it works for me, but the 30% "round number" doesn't take into account the reality of the cost of housing in all areas. I'd bet that people in other high-cost areas would agree (San Francisco and New York come to mind immediately). And I do save 10%. :-)