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.
Table of Contents
20-30-50 – Budgeting Ratio
The budgeting ratio says (the order is important only as it relates to the category, this sometimes is called the 50-30-20 ratio too!):
- 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%.
In fact, the Consumer Finance Protection bureau has rules about the “ability to repay” on “qualified mortgages” that set maximum percentages. The rule says a borrower has to have a total debt-to-income ratio that’s less than 43%. Freddie Mac and Fannie Mae have guidelines that lower the percentage to 36%. This includes other debts, not only mortgages, but sets an upper bound that’s very similar to the 30% rule we list. It can help inform how much you should spend on a house.
If you do get a big boost in income, try to invest the increased income rather than lift all the percentages up.
If you need help creating a budget, we have a budget spreadsheet available here. If that doesn’t work you, here is a list of other free budgeting spreadsheets you can try.
Using Personal Capital for Budgeting
One of the tools I use to track many of these ratios, whether it’s the budgeting ratio or the investing ratio (below), is called Personal Capital. It has the expense tracking features of Mint, is one of its best app alternatives, and it has a very robust and powerful suite of investment tracking and analysis tools.
If you’ve outgrown your budgeting software and graduated to caring about your investments, I recommend Personal Capital. You can read our full review here.
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 a larger 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 of 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. (most Americans do not own stock – don’t let this one decision stop you from investing!)
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 your 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.
Related: See the average net worth of Americans by age – it’ll shock you.
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?
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Holly Johnson says
These are important to remember! With that being said, some ratios work better than others for certain people, and the higher (or lower) your income, the less some of them make sense. A really high earner should not need to spend 50 percent of their income on needs, for example. It really depends on the situation!
But these are still good guidelines to remember. And people who apply them to their financial lives will likely be much better off!
Yeah, ratios are good guidelines. Just like how you need to change the baking process at high altitudes, you need to adjust these … but for most people in most situations, it’ll work better than guessing! 🙂
Ivana Rivers says
However, I agree with Holly’s comment. I own property and have ZERO debt, and my expenses add up to 24% (including mortgage) of my income.
For those who are not making six figures, it can be difficult to limiting non-investment spending to 50%.
I generally save much more than 20% of my income, which instills more discipline in not spending money in the 50%/other expenses category. I treat my investment money as a bill/expense.
I believe it would have helped to clarify that the 20/30/50 spending ratio should be applied to pre-tax income with taxes coming out of the 50%.
I appreciate the following comment: “If you do get a big boost in income, try to invest the increased income rather than lift all the percentages up.” I always recommend people to live below their means. If an individual were able to sustain a comfortable lifestyle with their previous income, they should apply any additional income toward investments (proceeding as if they didn’t receive a boost of income). I’ve always stuck by this philosophy since I was making a $25k salary and it has enabled me to reach the financial status that I’ve always aspired to.
Stefanie OConnell says
Great guidelines to remember. Just did the net worth one and I’m WAY behind, but that may be because my income has never even been close to this high before. Got some catching up to do.
That one does rely on more of a 3-5 year average rather than a one year snapshot. If you took a young person just starting to work, he or she would be hard pressed to meet that. 🙂
Good ratios to live by! In a recent read (The MoneySmart Family System: Teaching Financial Independence to Children) I learned about a 5/50/500 ratio that urges parents to educate their children about money.
The $5 stage: ages 0 to 5
The $50 stage: ages 6 to 11
The $500 stage: ages 12 to 17
The $5,000 stage: ages 18 to 23
The $50,000 stage: age 24 and beyond
The main argument here is the earlier in life you teach your children about money, the less expensive the lessons are.
I like that, it gives kids the tools to succeed as they move up the $ ladder. The skills to manage $50000 are different than $5 and a graduated system helps them.
Kalie @ Pretend to Be Poor says
It’s hard to say one of these is most important, but I think the first you listed–where your income goes–is essential because it makes some of the others possible. We aim to spend less than half our income so we can direct the rest to investments and early debt pay-off.
Yeah, that first one drives many of the others. If you spend too much, it’s hard to build up net worth because that relies on a bit of savings. It’s laudable that you’re aiming to save so much, it’s one of the only things can we can control when it comes to our financial future!
I’ve purchased a house, and life insurance, and currently have a 401k plan and have never even heard of these ratios! Thanks for sharing, particularly the net worth ratio. I’ve done the calculation and I’m behind a bit too.
Don’t get down on yourself if you’re behind on the NW ratio, it’s a number and many folks measure NW different. That said, it doesn’t hurt to make it a goal, right?
The Roamer says
I remember learning about 20/30/50 rule in college and it really was a great starting point.
I do have to say that 25x income for retirement savings doesn’t sound like a good rule in the sense of encouraging people to start. I just did the calculation at a few different earning incomes and the numbers looked more overwhelming then attainable. I use the 25x spend rule as that number is a lot less intimidating. 🙂
Tracy @ Financial Nirvana Mama says
Very simple to follow. Thanks for writing this article. I never considered 10X annual income for insurance..I would add that it depends on what you need the insurance for (funeral costs, mortgage payments, education costs)
The best thing to do is try to forecast your needs and buy enough insurance for that. If you aren’t sure you can do that well enough, the next best is to use the rule of thumb.
Sally Moore says
Followers of Christ generally take out the first 10% to give as God directs. Would you recommend that come out of the 50% or spread across the other percentages?
With tithing, it’s often what’s in your heart. I would do what feels right for you.
As Jim said, do what you honestly feel to be most correct. Personally, I take that 10% off the top. The remainder is my new 100% to divide up.
Andrew C. says
Thanks Jim! Quick and useful summary.
One question: When calculating the 20% from the 20-30-50 ratio, should I calculate solely on the basis of my monthly take-home or should it also include 401k contributions and employer match? For example, if my take-home is $20k, 20% would be $4k. However, I also make a monthly 401k contribution of $1,541 and my employer contributes $3,500 every month on my behalf, which if counted would satisfy the monthly goal without any additional cash savings.
Appreciate your consideration and look forward to your response!
Jim Wang says
Hey Andrew – I would include your contribution of $1541 (discounted however you like given that it’s pre-tax) in the 20% but I would not include your employer’s contribution. The idea is that you save enough of that pay because that means you aren’t spending it. The actual amount going into your retirement (or savings) is important but not for the purposes of the ratios.
These are not immutable laws but more like guidelines when you don’t want to be more exacting.
I am enjoying reading this article.
I am wondering if you can have a ratio for couples that need to split common expenses.
I think a common way is by ratio that is calculated based upon both incomes. That is understandable. The question is what kind of income from both sides? Gross , or net or disposable. It seems not fair for lower income w/o debts if go for disposable income.
Jim Wang says
If this is for you and your partner to equitably split expenses, it really depends on what you want to achieve. It sounds like you don’t need an answer from me but to have a discussion with your partner.