Learn two personal finance rules of thumb to take control of your two largest expenses: housing and transportation. Don’t get over-extended!
2 Personal Finance Rules of Thumb
Personal finance is hard. Everywhere you look there is someone trying to sell you something you cannot afford.
Expensive lattes and avocado toast get a lot of attention in the personal finance sphere. But, I think there are two areas that are much more important to focus on: housing and transportation.
Housing and transportation are the two largest expenses for US households. These two items eat up about a third of every dollar earned in the US. Plus, housing and transportation choices are made infrequently and can end up trapping you for years.
That means that the stakes are very high, and you need to be super cautious when choosing how much to spend on where you live and what you drive.
That’s why, I use and recommend two personal finance rules of thumb: one for housing and one for transportation.
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 article on the Undetailed Budget to learn the best way to take control of your monthly cash flow.)
The “How Much Can I Qualify For” Trap
Before we get to the two rules of thumb, I need to warn you of a trap. Nearly every person I know falls into this trap, and I want you to avoid it. It’s the “how much can I qualify for” trap.
You want to buy a car. You need to know how much you can afford. Either at the dealership, 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. However, 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.
That’s why I recommend shifting your goal from making payments to making progress.
Okay, now, let’s get to the rules of thumb!
Housing Expense Rule of Thumb: 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 of Thumb: 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 do these Rules of Thumb 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.
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.
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.
The Two Rules of Thumb Combined
Let’s put 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 will 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.
High Cost of Living Area
I have heard this reasoning so many times. I used to live in Chicago, which is very expensive. And, now I live in Boise, Idaho, which is quickly becoming more and more expensive every day.
In both cities, I hear people justifying spending more than this rule of thumb would allow on housing. They say that my rules may work somewhere else, but not in Chicago! And, certainly not in Boise!
These rules exist so that after you buy your house, you can afford to live in it!
If you live in a high cost of living area, then you have two choices: save up for longer until you are ready, or live in a less desirable house. This can mean buying a fixer-upper, or on the wrong side of the tracks. I know, that sucks. But, it is totally worth it!
If You Break the Housing Rule of Thumb
If you don’t put 20% down, you have to buy Private Mortgage Insurance (PMI), which protects the lender in case you can’t make your payments. You’re forcing yourself to pay for insurance and you’re not even the beneficiary!
If you spend more than 15% of your gross pay then you will have less money available for your other priorities, like retirement, healthcare, saving for your kids’ college, vacations, and whatever else you want! Sure, you qualify for that higher payment, but you will have no life!
And, if you spend more than 3x your annual household gross income, then you are setting yourself up to have a mortgage for longer than you should. Don’t assume that you will have a mortgage for your whole life. Your goal should be to pay off your house! In fact, it is the 12th step in my 12-steps to eliminate debt and build wealth.
I would much rather live in a modest house and have a good life than live in a fancy house and be stressed about money.
The point is, I don’t care how expensive it is to live in your town. What I care about is your ability to achieve your goals. And, if you break these rules, then your life is going to suck for years. And, nobody wants that.
Good Credit Equals More Danger
As you probably know, I have really good credit. The reason that I have good credit is because I am responsible with my debt and I don’t take on too much.
One of the things that happens when your credit score goes up is that lenders get more and more excited about lending you more and more money.
For example, let’s say you decide to refinance your mortgage to lower the interest rate. If you have a good credit score, your banker is going to let you know that with your income and your good credit, you qualify for a cash-out refinance! Or, maybe you should add a Home Equity Line of Credit, so that you have access to the equity in your home. You know, just in case you want to remodel that bathroom or update the kitchen.
Don’t do it.
If you want to remodel, then you can go find the money. You can even decide between paying cash or taking equity out of your house. Sure, I prefer cash, but that’s another topic.
The difference is that you decide and you drive the process. You are in control and you reach out to lenders to secure financing. It should never be the other way around!
If you get a letter in the mail to let you know that you qualify for some nonsense, do not fall for it. Throw it away.
Winning in personal finance is hard. Everywhere you turn there are temptations that can turn your budget upside down.
A lot of financial gurus focus on tiny things that can make you feel like you’ve made progress. For example, skipping that $5 latte. But, I prefer to focus on the big things. If you do two big things right, it can set you up for success for years!
That’s why, I recommend incredible discipline when choosing your housing and transportation. These two items eat up more money than anything else in your budget. So, use caution!
For housing: put 20% down, keep the payment under 15% of your gross monthly income, and do not spend more than 3x your annual gross income.
For transportation: put 20% down, keep the payment under 10% of your gross monthly income, and do not get a loan that will take more than 4 years to repay.
If you just follow those two simple rules of thumb, you will free up your cash flow and have much more freedom and flexibility in how you live your life. And, that will allow you to eliminate your debt and build wealth much faster. Oh, and you can still live a good life while you’re doing it!
What to Read Next
For more information, check out these articles that offer more detail about these topics. Enjoy!
- The Undetailed Budget: the Best Tool to Take Control of Your Money
- Shift Your Goal from Making Payments to Making Progress
- The 12 Steps to Eliminate Debt and Build Wealth
- How I Got An 830 FICO Credit Score and You Can Too
I hope this has been helpful! Join the conversation by adding a comment below.
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