Financial literacy month just ended, and many are interested in moving forward in an effort to create healthier finances. But where do you start? One of the best things you can do is to assess where you are right now. With brutal honesty, consider the following 6 areas of financial health to determine where you are at — and how far you might have to go in order to get your personal economy on the right track.
1. Housing Payments
The commonly used rule of thumb is that your housing costs should not exceed 28% of your monthly gross income. This doesn’t mean just your monthly rent or mortgage payment; it includes your property taxes and homeowners or renters insurance as well. I’d go so far as to consider including expected maintenance and utilities in this number. While some banks will still approve you for a higher payment, or will still offer a low teaser rate or interest only loan in order to make it appear as though you are within the accepted limit, it can be a bad idea to take advantage of such “deals.” Look at where you are at, and see if you can either boost your income or reduce your housing costs if you are not with in this 28% number. Figure this by taking your monthly income and multiplying it by 0.28. If you make $5,000 a month, 28% of your monthly income is $1,400.
2. Debt
Next, consider your debt. Add up your monthly minimum payments. This includes credit cards, auto loans, student loans and even your mortgage. If it is a debt obligation, you need to add in your monthly payment. Your total debt payments should be no more than 36% of your gross income. So if you are making $4,000 a month, your total debt payments should be no more than $1,440 each month. You should be working to reduce your debt anyway, but if your debt payments account for more than 36% of your monthly income, it is time to start thinking about an aggressive debt reduction plan.
3. Emergency Fund
In the past, financial experts recommended a three-month, minimum, emergency fund. The recent recession has forced many to reconsider that number, and recommend an emergency fund that includes six to 12 months of expenses. Add up your expenses for a typical month (this is more easily done if you have personal finance software), and multiply that by the number of months you would like to have a safety net for. If your monthly expenses add up to $3,500, that means you will need $10,500 for a three-month emergency fund, $21,000 for a six-month fund and $42,000 for a 12-month fund. If you don’t have an emergency fund, start building toward a three-month version. Build it little by little, setting aside what you can in a high-yield savings account.
4. Insurance
Protecting your assets and your financial situation is the important function of insurance. One large sickness (in the U.S.) or home-destroying disaster can ruin you financially. Even auto accidents can put strain on your finances if you are not adequately insured. If you have dependents counting on your income, it is vital that you purchase a life insurance policy that can provide for them when you are gone. Review your needs, and make sure you have the insurance you need to protect your assets and provide for your family.
5. Retirement Savings
Prepare for the future with a retirement investment plan. This vital if you want something approaching material comfort in your later years. Look at what you are setting aside each month for the future. And make sure you are taking advantage of the free money offered by a company match. You can use investment calculators and other tools to help gauge whether you are on the right track. If you can, it is best to max out tax-advantaged retirement accounts before you invest in taxable accounts.
6. Diversification
Look at your retirement account and your other assets and holdings. Are you diversified? Having a mix of assets, including stocks, bonds and cash, can help you limit your risk while still promoting growth. If you have a bit higher risk tolerance, it can be helpful to include real estate, commodities and currencies in your portfolio. Consider your goals, current situation and how much time you have left until retirement to help you create a portfolio that is properly diversified for your needs.
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Why would you suggest a housing payment of no more than 28% of your gross income? It’s not your gross income that pays the bills…it’s the net. I believe Dave Ramsey says no more than 25% of your net income on a house with no more than a 15 year mortgage. We did this for our house, and it’s a great feeling. My belief now is that if you can’t buy a house on a 15 year mortgage, you shouldn’t look at it.
What I said was that 28% was a widely used rule of thumb. Personally, I think that you should base it on your net, including maintenance and utilities, and keep it to something closer to 25%. My own housing costs are 20% of my net income.
And, it is worth noting that 28% is what banks use as part of the 28/36 qualifying ratio.
Debt is not necessarily bad as long as we have control over it. It’s the livelihood of many folks and companies as well. We buy into a dwelling, cars, vacations for our livelihood. It’s just that we ought not go overboard. We must be able to pay our debt while still alive. Our bad habits should not concern our kids once we are gone.
I do believe that 28% of gross is high for housing. I would never give blanket advice like that to someone. The difference between gross and net can vary between persons.
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