Everyone has a unique financial situation and when it comes to financial planning, a one-size-fits-all approach isn't realistic. There are, however, some common rules of thumb that can help you gauge your progress as you work toward your financial goals. While following these rules won’t guarantee success, they can put you on the right track if you're trying to pay off debt, grow wealth or achieve a comfortable retirement.
Rule #1: Keep Debt Under Control
Ideally, you have no consumer debt but again, that's not always realistic. You may have student loan debt, credit cards, a car payment, or another type of debt you're trying to manage. In terms of how much debt is too much, most financial planning 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. Consolidating or refinancing student loans, for example, could reduce your interest rate and allow more of your monthly payment to go toward the principal. You could also use a 0% balance transfer offer to combine your credit card balances and minimize interest charges
Look for a balance transfer credit card that charges no balance transfer fee to minimize the amount you'll have to repay.
Rule #2: Avoid Being House-Poor
Figuring out how much to spend on a home is another important financial planning rule to follow. To do that, start by calculating your debt-to-income ratio using the 36% guideline for the sum of your monthly debts. Then, consider how much you could spend on a mortgage payment without exceeding that 36% cap. This is generally the amount you could reasonably afford for a home.
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. This is a rough guideline but it can give you an idea of what you can afford for a mortgage to avoid becoming house-poor.
Take advantage of home affordability calculators, which can give you an idea of how much home you can afford to buy, based on your income and debt.
Rule #3: Aim to Save at Least 10% of Income
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 your 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 3-6% 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.
Once you've maxed out your employer's retirement plan, consider opening a traditional or Roth IRA to allow for additional tax-advantaged retirement savings.
Rule #4: Don't Overlook Emergency Savings
An emergency fund is used to cover expenses when there is a sudden loss of income or another 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.
Then again, you may decide to save more or less, depending on your financial situation. If you're self-employed, for example, you may want to increase your emergency savings to nine or 12 months' worth of expenses instead. On the other hand, if you're single, make a decent income, and have no debt, then a $1,000 starter emergency fund may be sufficient. You can continue adding to your savings fund over time through automatic deposits.
Rule #5: Be Realistic About 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. But, that number may be higher or lower, depending on the type of lifestyle you plan to live in retirement, how much debt you're still carrying, and your overall health. Health care expenses can eat a significant portion of your retirement budget if you don't have Medicare or sufficient health insurance to handle those costs.
Another way to think about how much you'll need for retirement 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. Using a retirement calculator to estimate your savings needs can help you develop a plan for saving, investing, and growing your money well before you need to retire.
The Bottom Line
These five rules aren't the only financial planning guidelines to keep in mind. But, they can give you a solid foundation for building wealth over the long term. If you're working with a financial advisor, they can guide you in fine-tuning your strategy. And if you don't have an advisor yet, consider what working with one could help you achieve where your money is concerned.