Posted by Hakyun Morrissey.
Sometimes you’re standing in line at Starbucks, behind some perfect stranger—brand name shoes, clothes, designer bag—and you catch yourself thinking: How can they afford it? How much do they make? Wouldn’t that bag be perfect for me?
Before trying to justify to yourself why you deserve, need that bag, it helps to keep a few budgeting rule-of-thumb numbers in mind—to guide you away from temptation and towards smarter decisions:
1) You can afford a home that costs roughly 3x your annual income. This ratio is used by many real estate agents, based on the median U.S. home price/the median annual income. It’s useful as a general guideline for would-be homebuyers nationwide—unless you live in New York, Los Angeles or some other less-affordable metro area, where you will struggle to find a property that costs three, or even five times your annual income.
2) Don’t spend more than 30% of your income on rent or mortgage.
Obviously, this becomes tricky if you’re renting an apartment in one of those pricey metro areas. Still, the general recommendation to allocate 30% or less on housing can help you to rein in your spending and live within your means. If you’re forking out well over that recommended amount, it may be time to downsize, find roommates or move to a more affordable neighborhood.
3) You can devote 30% of your paycheck to “nice-to-haves.” This follows the 50/30/20 rule, that says 50% of your income should cover non-negotiables, including the roof over your head, the food on your table and the clothes on your back. Some of your “essentials” might actually belong in the “negotiables” or “nice-to-have” bucket, which accounts for the 30%. Do you really need that fourth pair of sneakers? If you’re a runner and need them for safety and performance, they may be considered non-negotiable; however, if they are for going out and your red pair simply isn't red enough, they may be negotiable. You are the best judge of this—just be honest with yourself.
4) You should be saving 20% of what you make. The final piece of the 50/30/20 rule is arguably the most important. Since the difference between wants and needs can be so murky and subjective, some people prefer the simpler 80/20 rule, also known as the Pareto principle, which can be applied to all areas of life. For example, companies often find that 80% of their business comes from 20% of their clients. Similarly, this 20% of your income, when saved and invested, can have an outsized impact on your wealth and well-being.
5) Ideally, your nest egg should equal 1x your salary by age 30, 3x by age 40, and 5x by age 50. This provides a good motivational rule of thumb to help savers who aren’t taking full advantage of their employer retirement plans and/or IRAs. Don’t worry if your savings balance is smaller than it should be, based on your age. Just use this equation to help put you back on track for a comfortable retirement. Revisit your savings rate and how you are invested, at least once a year. Try to put more into an IRA so that in five to 10 years, you’re closer to where you should be.
If numbers aren’t your thing, remember this phrase: “Pay yourself first.” Similar to a mantra, it will ingrain itself in your mind and eventually lead to positive behavioral changes. But these five numbers serve as useful benchmarks when you find yourself wondering: Am I spending too much and/or saving too little?