2 Budgeting Rules to Add FIRE to Your Finances

In a previous post, I laid out how to create an Undetailed Budget with exactly four categories: Income, Recurring Expenses, Personal Spending, and Savings.

But, how do you know if your Recurring Expenses are right for your income level?

Well, it turns out, there are two budgeting rules of thumb that I follow to keep my recurring expenses under control. And, that allows me much greater flexibility in my Personal Spending and Savings.


Housing and Transportation Take Priority

At some point, almost all personal finance advice gurus will tell you to cut back on your $5 lattes. I won’t.

Here’s why:

The two biggest monthly commitments for most households are housing and transportation.

Let’s say you buy five lattes per week, that’s $25 per week. There are 52 weeks in a year, so those lattes cost you $1,300 per year.

Compare that to the median mortgage payment in the US (according to Census data), which is $1,030 per month (over $12,000 per year).

The average car payment in the US (according to Edmunds) is $550 per month ($6,600 per year).

So, even if you completely gave up lattes for a year, the savings would not even cover one month of housing and transportation.

That’s why it is absolutely vital that you take extra care not to overspend on your house or your car. Those two purchases can sink your finances for years. And, you generally can’t just decide one day to ‘cut back’ on your housing and transportation expenses. Mortgage payments, rent, and car payments are not flexible.

(Side-note: I’ll never tell you to cut back on your lattes… but that does not mean you can go crazy with your Personal Spending. Check out my post on undetailed budgeting to learn how to take control of your finances by memorizing, learning, and internalizing just four numbers.)

The “How Much Can I Qualify For” Trap

Nearly every person I know falls into this trap.

You want to buy a car. You need to know how much you can afford. Either at the dealership or at a bank or online, you find out how much debt you can qualify for.

You want to buy a house. You go to your mortgage person and ask: “How much do I qualify for?”

Here’s the problem: if you are shopping for a house or a car then you absolutely need to know how much you qualify for because you should not be shopping for a car or a house that you are incapable of purchasing. But, just because you qualify for a certain amount does not mean that you should spend that much on your house or your car.

When the lender tells you how much you qualify for, they are answering the question: how much can they give you, based on your current financial situation, and expect you to be able to pay them back on time every month?

But, the question you should be asking yourself is: how much should I spend on housing and transportation so that I can keep myself in excellent financial shape?

Often, the answers to those two questions are wildly different.


Housing Expense Rule: 20 / 3 / 15

When buying a house, you should put at least 20% down. The purchase price should be no more than 3-times your current annual gross pay. And, the payments should be no more than 15% of your monthly gross pay.

Transportation Expense Rule: 20 / 4 / 10

When buying a car, you should put at least 20% down. The loan should be for no more than 4 years. And, the payments should be no more than 10% of your monthly gross pay.

Pro Tip: After your car is paid off, put the amount of the monthly payment into a savings account. Then, in about a year, you will have enough for a down payment on the next car.

Master Tip: Continue to put the amount of the monthly payment into a high-yield savings account until you have enough to pay cash for the next car.


How does this work in the real world?

Let’s go through a hypothetical example. Assume your household income is $60,000 (similar to the US median income). A gross income of $60k will have take-home pay of about $45k, which is about $3,750 per month.

Housing

Based on the housing rule, you should not spend more than $180,000 purchasing your house. Your down payment should be 20%, which is $36,000. That means your mortgage would be about $144,000. If your mortgage is 30 years and your interest rate is 5%, then your payment would be about $775 per month. And, $775 is just over 15% of your gross pay.

And, don’t forget, this is just your mortgage payment. You will also have to pay taxes, insurance, utilities, etc.

Don’t be confused. There are many mortgage programs, especially for first-time home buyers, that you may qualify for that would allow you to purchase a house for more than $180,000, or to put less than 20% down.

Just because you qualify for a program, does not mean you can afford it.


Tansportation

For your car, 10% of your monthly gross income is $500, which would be the payment on a loan for about $21,700 for four years with a 5% interest rate. If you have put 20% down, then the maximum purchase price would be about $27,000.

Again, you may qualify for a loan without a down payment. You may qualify for a fancier car. That does not mean you can afford it.


Let’s add this all together:

You make $60,000 per year, so your take-home pay is about $45,000.

Monthly, you receive about $3,750.

$775 is the maximum you should allow for your mortgage. That’s just over 21% of your take-home pay.

$500 is the maximum you should allow for your car. That’s just over 13% of your take-home pay.

Add them together, and your mortgage and car loans are $1,275, which is 34% of your monthly take-home pay. That means that you have $2,475, which is 66% of your take-home pay left for other Recurring Expenses, Personal Spending, and Savings.

I’m not saying you should spend this much on housing and transportation. I’m saying that this should be the maximum you let yourself spend on your mortgage and car loan.

Someone with excellent credit may be able to qualify for a larger mortgage or a fancier car. But, remember, those calculations are solely based on your ability to pay the loan back. You need to make these calculations based on your ability to achieve all of your financial goals, which I’m sure add up to more than just paying back your debts.

I hope this has been helpful! I welcome your comments with your thoughts and questions.

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