In my last blog post I discussed 5 key principles that can help people get started on the right financial track. Within this post I will dive deeper into Principle 1, which is “Know Your Numbers and Live Within Them”. Below is a list of three key numbers that everyone should know and strive to live within. For all of the examples below, I will be using a gross income of $50,000 per year or $4,166 per month.
- Outflow Rate = ≤100%
- Savings Rate = ≥15%
- Housing Rate = ≤25%
1 – Outflow Rate
Understanding how much money comes in and how much money goes out seems like common sense, but surprisingly 68% of Americans don’t have a budget. In the most basic sense, everyone should be able to calculate how much money comes into their household & how much money goes out. Once a person has those two numbers they can simply divide their outflows (money going out) by their inflows (money coming in) to get their “Outflow Rate”. (Outflows/Inflows = Outflow Rate) At a minimum this number should be less than 100%. ($4,000/$4,166 = 96%.) Although it seems like a no brainer, understanding your inflows and outflows is essential to building financial wealth.
2 – Savings Rate
“How much money should I be saving?” is by far the most common and potentially most important question I am asked. That is because the most impactful factor in a person’s financial health is their ability to save money early and often. Everyone should strive to save greater than or equal to 15% of his or her income, yet as of June 2016, the national average is only 5.5%. This savings percentage can be broken up and contributed into one or more of the following areas:
- General savings/emergency fund (cash of 3-6 months of expenses)
- Investment accounts (401(k), Roth 401(k), IRA, Roth IRA, 403(b), 457(b), taxable accounts, etc.)
- Real estate or other business investments
- Extra debt payments beyond the minimum required
- Extra principal payments on your home mortgage
For example, if the household income is $50,000 per year, then $7,500 per year should be put towards one or more of the items listed above. The Savings Rate ($7,500/$50,000 = 15%) is calculated by dividing your annual savings by annual income. (Savings/Income = Savings Rate)
Target Savings Rate = Greater Than or Equal To 15%
3 – Housing Rate
“How much house can I afford?” is another common question people ask themselves. To start, a healthy and recommended housing rate should be no greater than 25-28% of one’s household income. Living within this number is extremely important now, and in the future. One of the most common ways people get into financial trouble is by purchasing a home they cannot afford. Although you may think you can “afford” the mortgage, additional expenses and unexpected repairs are a guarantee with homeownership. Here is a link to an affordability calculator that can help you identify how much house you can actually afford. When using this tool it is important to be honest and realistic with your inputs)
If the household income is $50,000 per year, then no more than $12,500 per year or $1,050 per month should be spent on a mortgage/rent. ($12,500/$50,000 = 25%) The Housing Rate is calculated by dividing your annual mortgage/rent expense by your annual income (Housing Cost/Income = Housing Rate).
Target Housing Rate = Less Than or Equal To 25%
In sum, you absolutely must know your numbers if you want to plan your financial future. Once you understand your outflows, your savings rate, and other key investment factors, you will feel more in control.
Please feel free to contact me if you questions.
*CJ Harrison is an Investment Adviser Representative of Arista Wealth Management, LLC, a Registered Investment Adviser