Ratios are everywhere.
Have you ever baked a loaf of bread? The recipe always looks complex but it relies on one key ratio: 5 parts flour to 3 parts liquid.
Fresh pasta is just 3 parts flour and 2 parts egg.
These ratios are important because if you can’t remember the specific recipes, a ratio will save the day.
The same can be true of money ratios. These aren’t naturally occurring ratios, like the golden ratio, but man-made rules of thumb that can be extremely valuable starting points.
20-30-50 – Budgeting Ratio
The budgeting ratio says (the order is important):
- 20% should be immediately saved (goals or retirement) or put towards paying down debt.
- 30% should be the maximum you spend on housing.
- 50% should be spent on everything else.
If your take home pay is $5,000 a month, you should aim to:
- Put at least $1,000 towards your retirement accounts, emergency fund, or your debts.
- Pay no more than $1,500 a month in rent or a mortgage.
- Pay no more than $2,500 for everything else.
Why does this ratio work? This ratio is valuable because it gives you a healthy and achievable target for savings and housing. If you are saving 20% of your income, you’re ahead of most people and are setting yourself up for financial success down the road. Average retirement savings is dangerously low. Thirty percent (30%) on housing creates a good anchor for how much you should pay, stick with it and you are able to spend more elsewhere.
Can you spend 31% on housing? Sure, you can do whatever you want. But that 1% comes at a cost to something else, hopefully that 50% and not the 20%.
If you need help creating a budget, we have a budget spreadsheet available here. If that doesn’t work you, here are a ten free budgeting spreadsheets put together by my friend Bob.
6X Monthly Expenses – Emergency Fund Ratio
How much should you have in your emergency fund? Experts say at least six months of expenses.
Some people believe you need 12 months, others say 3; I say start with saving up $1,000. Get yourself to $1,000 in emergency fund savings as your interim goal, then follow the ratio through to the full six months. Figure out what you’ll do once you hit six months. Maybe you ladder it in certificates of deposit to boost the earnings a meager amount. Maybe you just leave it be. Either way, you won’t go wrong having six months.
Why does this ratio work? Six months is a good target and gets you on the path of saving. The biggest and likely emergency is job loss and six months will give you ample time to start cutting expenses back while you look for a new one. If you want to be more conservative, make it 12 months.
Limit Mortgage to 2.5X Your Income – Mortgage Ratio
This is another ratio that’s built off a basic premise – you should spend less than 30% of your take home pay on housing.
If you make $120,000 a year, this means your mortgage shouldn’t be greater than $300,000. If you put a 20% down payment, that’s a house worth $375,000. If you want more house, you need to come up with a bigger down payment.
Why does this ratio work? If you follow this ratio and assuming an interest rate around 4%, your monthly mortgage payment works out to be ~28% of your take home page. Assuming a $120,000 annual salary, your monthly take home page is about $6,500. A 4% 30-year mortgage is around $1,800 assuming a 1.25% property tax.
120 Minus Your Age – Investing Ratio
When you are building your investment portfolio, asset allocation can be a tricky problem to solve. It can be so tricky, sometimes it’ll delay your investment. Don’t let it have that power, this rule of thumb has been tested over time and it works pretty well.
The percentage of your assets in equities should be 120 minus your age. If you’re 40, you should have 80% of your investment assets in stocks and 20% in bonds. As you age, the allocation will shift from equities to bonds. If you feel that you’re a more risk averse person, you can use the 100 Minus Your Age ratio.
Why does this ratio work? It’s simple and it’ll get you out of analysis paralysis. Once you’re invested, you can start thinking about more complicated diversification issues like what kinds of equities (international vs. domestic, small cap vs. large cap, etc.) and really drilling down your portfolio. If you try to tackle it all at once, you may be overwhelmed and punt the decision.
Save 25X Your Current Income – Retirement Savings Ratio
How much money do you need to save into a nest egg to retire? Experts believe that a safe withdrawal rate in retirement is 4% of your assets. By withdrawing just 4% a year, it’s likely that you retirement funds will last as long as you do. I’m just expressing the safe withdrawal rate of 4% as a ratio, which is 25X your current income.
This is a very conservative ratio because your income is likely greater than your expenses (you are saving, right?), but who can predict your expenses in retirement? The important point is that you have a target and 25X is as good a target as any.
Why does this ratio work? It relies on the safe withdrawal rate of 4% and conservatively relies on your income being the benchmark. The biggest challenge in retirement savings is getting people to save, having an easy to understand target is the first step to getting people to do it. With the 25X Your Current Income as a starting point and 120 Minus Age allocation rule for where to put your money, you eliminate analysis paralysis as a cognitive barrier.
Age X Pretax Income / 10 – Net Worth Ratio
This ratio comes from the bestselling book “The Millionaire Next Door.”
I think age is a bad factor in any financial equation. A 25-year old medical student and 25-year old bartender are on different income earning trajectories but at the age of 25, the bartender will have a higher net worth. He probably will have a higher net worth at 35 too, but I suspect at 45 and 55 the doctor and his higher earning power will outpace the bartender.
That being said, it is as good a target as any. Just as 120 Minus Age is a “good enough” ratio that will get you started, this one is a fine enough target goal. Just don’t get down on yourself if you’re 25, earning $60,000 a year and don’t have a net worth of $150,000.
Why does this ratio work? Net worth is a tricky metric to use but if you start tracking it, you are already winning. I track my net worth to understand and chart progress, not to compare against my peers. This ratio works because it’s a reasonable target, more so when you’re older, and it gets you thinking about your long term financial situation.
10X Your Annual Salary – Life Insurance Ratio
A ratio for life insurance can be difficult because there are so many life situations. If you’re 28 and have two young kids, you will need more life insurance than someone who is 45 and with two adult children who are on their own. Life insurance has many different goals but the primary goal is to replace your income.
If you’re younger, I’ve seen the ratio expressed as 15X your income. As you age, this ratio drops lower and lower.
Why does this ratio work? 10X your annual salary and a safe withdrawal rate of 4% means your family will get about 40% of your annual salary each year. If you’re sticking to the 50/30/20 budgeting ratio, you realize the 40% replacement only covers 30% housing and 10% of the discretionary. What gives? Insurance companies assume your spouse will be working and supplement the remainder.
Armed with these ratios, you can do a lot of good for your finances. Which ratio do you think is the most important?