When you start Googling financial planning topics, you’ll undoubtedly come across rules of thumb. How much house can you afford? How much can you take out of your IRA each month without running out of money in retirement? What should you spend on an engagement ring? How much life insurance do you need? Are you saving enough for retirement? How should you divide my portfolio between stocks and bonds? There are quick formulas all over the Internet that answer all of those questions. In some cases, rules of thumb or benchmarks are helpful. In other cases, they can be costly.
Over the coming weeks, I’m going to break down some of the pros and cons of various financial planning rules of thumb. This week, we’ll focus on two popular ones: how much you need to save for retirement, and how much house you can afford.
Financial Planning Rule Of Thumb 1: Save 10-13% Of Your Income For Retirement
This benchmark is mostly self-explanatory. But, know that the 10-13% includes both employee and employer contributions, and that the “income” figure is gross (i.e. before taxes).
Many employees work for companies that match the employee’s contribution to their 401(k) up to, say 4% of their salary. I like that this rule of thumb encourages you to save more than just what you’re eligible to receive from a company match. Contributing enough to be fully eligible for a match is a no-brainer, but it usually takes more than saving just 3% or 4% of your income (plus a match) to be able to retire.
If you started saving for retirement in your 20s, contributing 10-13% of your income might be enough. This is particularly true if your vision of how much you want to spend in retirement isn’t all that different from what you spend today. Further, if you don’t have a very low or very high income right now, this might work.
Finally, I like its simplicity. If you’re flying blind and have absolutely no clue how much you should save, and you can’t afford the help of a professional financial planner, this is a good place to start.
Pensions Throw Off The Calculation
A benchmark for retirement savings can be completely irrelevant for a lot of folks. Pensions are one of the most common reasons for that. Traditional pensions are less common than they used to be, but they’re definitely still around. The 10-13% rule of thumb is based on the assumption that the employee is going to pay for their retirement using something like an IRA, 401(k) or 403(b). If you’re earning a pension, you’ll get a stream of income during retirement. That means you won’t be fully reliant upon money that you saved in an IRA or 401(k). Does that mean you should save less than 10-13% if you’re eligible for a pension? No, but it’s a factor that affects how much you need to save.
Household Income Changes Recommended Savings Rates
Another big problem with this rule of thumb is related to how much you make. If your household income is $70,000 per year, a 10% savings rate might be unattainably aggressive. If your household income is $400,000 per year, you’re not pushing yourself if you’re only saving 10%. You probably need to be saving more than that.
Age Affects Recommended Savings Rates
Another factor that throws off the rule of thumb is if you don’t start saving for retirement until your 30s or 40s (or worse, later). If you’re 42 years old and are just now in a position to save for retirement, you’ll probably need to save more than someone who started in their 20s – more than just 10-13% of your income.
Retirement Spending Goals Matter
Retirement goals are another reason this rule of thumb often fails people. What if you want to spend more in retirement than what you currently spend? Maybe you’re 30 years old and are just beginning your career, and don’t make much money. So, by default you don’t spend much. Maybe when you retire, you’d like to take some nice trips, give generously, and live in a city that costs more. That means you’ll be spending a lot more than what you spend today. Saving 10% of your income probably won’t allow you to enjoy the type of retirement for which you hoped. That means you’ll have to be more aggressively saving than someone who earns the same income as you do today, but who plans to live a more modest lifestyle in retirement.
Financial Planning Rule Of Thumb 2: A house is affordable if the mortgage payments is below 28% of your income, and total debt payments are below 36% of your income.
These rules of thumb are primarily about your “debt-to-income” ratio, which measures your monthly debt payments compared to your monthly income. The 36% ratio adds up all of your debt payments (mortgage, student loans, vehicle loans, personal loans), and divides that sum by your monthly income. The 28% uses the same calculation method, but only includes your mortgage.
The 28% ratio is a good way to limit the size of house you buy. Mortgage lenders will often times approve you for much larger mortgages, but limiting yourself to 28% is an easy way to control spending. The 36% ratio is also helpful, because lenders will consider you to be a lower risk borrower if your total debt payments make up less than 36% of your monthly income. That means you’re eligible for better terms.
Monthly Payments Are Dangerous Measures Of Financial Decisions
Making financial decisions purely based on “monthly payments” is a recipe for disaster, and these ratios are purely based on monthly payments. For example, leasing vehicles for your entire life might be cheaper than buying a new vehicle from a monthly payment standpoint. However, leasing is much more expensive in the long run than purchasing that same vehicle and keeping it for, say 12 years. Same deal with your house. Don’t focus on the monthly payment. Of course, you need to be able to afford the monthly payment. But you should also consider important factors like the total price of the home, and your other financial goals.
Big Purchases Might Have Unintended Consequences
For example, let’s say you had a $500,000 sitting in an investment account. You already owned a $300,000 house with no mortgage, and you were considering purchasing a new home that was worth $800,000. You could use the $500,000 and sell your existing home to purchase the new home without needing any mortgage. So what’s your monthly payment compared to your income? 0%. That’s well below the 28% rule of thumb.
Does that mean you can afford that $800,000 house? Not at all. You’d need to think about what other things that $500,000 could be paying for. Maybe you’ll need it for retirement. If you used that money for a new house you might have to sell it in 10 years to pay for your monthly bills. Perhaps you didn’t realize how much of an effect that home purchase had on your retirement plans. Maybe you’ll need it for your kids’ college expenses, and spending on a home means your kids will have to rely on student loans. That might prevent them from owning their own home for 15 year after they graduate. The list of other uses for that money goes on, and some of these are pretty unlikely. Here’s my point: the cost of the home is about a lot more than just the monthly payment compared to your income. This principle applies whether you’re using cash or debt to pay for your home.
Bottom Line – Financial planning rules of thumb usually oversimplify complex issues
Financial planning rules of thumb have some value, but they’re unreliable when they’re used in a vacuum. You need to consider more of your financial picture than just quick benchmarks or ratios. Too much is at stake to get it wrong. It’s possible to consider the bigger picture on your own. But, if you value the organization, accountability and expertise that comes with hiring a professional financial planner, contact us. We can discuss whether we might be a good fit for each other. In the meantime, keep an eye out for future blog posts. I’ll continue to examine more rules of thumb – what they get right, and what they get wrong.