Cracking the Money Code: 45-15-15

Amy could not believe what was happening. Three years ago she left her local bank dancing with joy. She had just qualified for a mortgage that was 8 times her annual income. Amy figured the bank knew what they were doing so she went for it. She used a 3/1 ARM (i.e. an adjustable rate mortgage) to purchase a condo for $400,000. Life was good until her interest rate reset at the start of year four. Amys new monthly mortgage payment ate up over 50% of her gross income. Looking at her checkbook, tears rolled down Amys face. After she paid her mortgage, her car payment, and her student loans, there would be barely anything left to live on! Sadly, our country is full of people like Amy. Daily, well-intentioned individuals find themselves in financial trouble because they are not aware of how much they should strive to save for the future versus how much they can safely spend today. This lack of understanding is particularly dangerous when it comes to spending on big-ticket items like a home or a car. As such, weve come up with a keep-it-simple rule of thumb for your spending. We call it the Power Trio of Budgeting.

If you have an average salary taxes will consume roughly 25% of your income. Thus, after taxes youll be left with 75% of your gross income to spend. (*Note, if you have an above average income or live in a part of the country such as the East or West coasts with above average tax rates, your effective tax rate could be 30% or higher and youll need to adjust the Power Trio percentages accordingly).

After taxes, the largest piece of the Power Trio pie is what we call foundation expenses. Its 45% of the pie. This foundation slice includes your basic needs such as housing and transportation related expenses. This was the slice that tripped up Amy. In fact, many people inadvertently blow their budgets by spending too much in this area. Thats why we recommend that you keep your housing costs to 25% or less and your transportation-related costs to 10% or less of your gross income. If you live in a city with high cost real estate where utilizing public transportation is more the norm (e.g. New York, Boston, Washington, San Francisco), you might want to blend the two categories together. For instance, you may allocate 30% of your gross income to housing and 5% to transportation. The key point, however, is that if your housing plus transportation costs are much more than 35%, youll have a hard time paying for the rest of your foundation expenses. Remember, your goal is to keep your total foundation costs to 45% or less. The rationale behind the guidelines for your foundation expenses is simple. Its all about ensuring you have enough money to both enjoy today and tomorrow. What we mean is that by keeping your foundation costs to 45%, youll be able to spend 15% of your gross income on fun today (yes, because having fun is important!) and still save 15% for your future. Heres a look at what types of expenses fall into each category. Foundation Expenses
Housing: your monthly rent OR mortgage payment, homeowners insurance, and property tax as well as other routine bills like utilities, phone, cable, internet. Transportation: your car payment, insurance, gas, maintenance, monthly tolls, and parking if you drive and/or your monthly bus, train, or subway pass if you take public transportation. Basic groceries/supplies: food, toiletries, cleaning supplies. Debt repayment: any fixed payments on student loans or other debt (including credit cards). Other Foundation: health insurance, non-reimbursed medical expenses, life insurance, childcare costs, charity, and ESSENTIAL clothing.

Fun Expenses
Fun food take out, restaurants, coffees & snacks, dinner & drinks with friends, etc. Fun clothing your WANT clothes, shoes, accessories, and jewelry. Entertainment movies, concerts, CDs, DVDs, magazine subscriptions, books, newspapers, hobbies, etc. Personal gym membership, facials, manicures, makeup, etc. Other vacations, gifts, pets.

That 15% for your future will break down to roughly 5% for more near terms needs such as your emergency fund and down payments for big-ticket items like a home or car as well as 10% specifically targeted for your retirement. Most of us intuitively understand the need for a 3 to 6 month emergency fund and the need to save for big-ticket items such a down payment on a home. However, what about that 10% we suggest targeting for retirement whats the rationale behind that? Lets do the math.

ESTIMATE OF WHAT YOULL HAVE IN YOUR RETIREMENT NEST EGG BY AGE 65*
If you routinely save 10% of your gross income every year Your Annual Income Today
20 $20,000 $1,438,000 $885,000 $542,000 $329,000 $197,000 $115,000 $64,000 $30,000 $2,157,000 $1,328,000 $813,000 $493,000 $295,000 $172,000 $95,000 $40,000 $2,876,000 $1,770,000 $1,084,000 $658,000 $393,000 $229,000 $127,000 $50,000 $3,595,000 $2,213,000 $1,355,000 $822,000 $492,000 $286,000 $159,000 $60,000 $4,313,000 $2,656,000 $1,626,000 $987,000 $590,000 $344,000 $191,000 $70,000 $5,032,000 $3,098,000 $1,897,000 $1,151,000 $688,000 $401,000 $222,000 $80,000 $5,751,000 $3,541,000 $2,168,000 $1,316,000 $787,000 $458,000 $254,000c $90,000 $6,470,000 $3,983,000 $2,439,000 $1,480,000 $885,000 $515,000 $286,000 $100,000 $7,189,000 $4,426,000 $2,710,000 $1,645,000 $983,000 $573,000 $318,000

Your Age

25 30 35 40 45 50

*Assumes your investments grow 10% a year, with annual salary increases offset by annual inflation. All figures rounded to the nearest $1,000.

This chart shows you how much youd have in your retirement nest egg depending upon the age at which you started saving and your salary. What does this mean for real life? Well, you can spend up to 5% of your nest egg each year in retirement (if you invest wisely) and have reasonable odds of not running out of money for a traditional 30-year retirement period. To calculate your annual retirement income, multiply the figure in the chart that corresponds to your income level and age you started saving by 0.05. Youll notice that if you start savings in your twenties, you should easily be able to maintain your standard of living. However, if you wait until your forties, youll have less than half the spending power you had when you were working. (All is not lost if you are reading this in your forties or beyond youll just need to save more than 10% for your retirement). So go for it. Crack the money code by using the 45-15-15 rule of thumb, and start living your life from a position of financial strength!

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