A Financial Yardstick for Everyone
March 27, 2013One thing I’ve come to learn after being on the financial helpline for 6.5 years is that some employees simply want to know how they are doing relative to everyone else. No matter how I try to encourage them to consider themselves and their circumstances unique, human nature drives us to want to know if we are ahead, behind, or in line with our peers. We crave some type of yardstick to know if we are measuring up.
On this note, Lisa Scherzer posted a blog last week called 7 Signs You’re a Paradigm of Financial Health. In her post, she outlines seven signs that can help the average person gauge whether or not they are ahead, behind, or on track with where they should be financially. Here is an overview of each sign, along with my personal insights:
Sign #1: By age 40, you’ve accumulated 1 to 3 times your annual income.
I can already hear some of you groaning as you consider your own level of accumulation relative to this benchmark, but don’t lose hope. According to the blog, you can include savings in the bank, your retirement plan, and even home equity as part of the equation. What could be holding you back is debt.
If you are under 40, take advantage of the time that you have to reach this goal. Participate in your company’s retirement plan (at least up to the matching level, if available), and make two of your primary goals building up an emergency fund and getting out of high-interest debt. If you plan to live in the same area for a while, you may also want to consider buying a home.
If you are at or above 40 and have not reached this benchmark, now is the time to really step things up. Scale back on your living expenses as much as possible in order to increase your savings. Take advantage of retirement plan auto-escalation features that automatically increase your contributions over time. If you are age 50 plus, you should take advantage of catch-up contributions as well.
Sign #2: If you’re part of a dual-income household, you can cover your fixed expenses with one income.
All of us, by human nature, tend to live a lifestyle that matches our income, so when there are two incomes, our lifestyles naturally go up. The problem is you never know when one of those incomes may go away. If you require both incomes to support your fixed expenses, you are setting yourself up for trouble.
In order to revert to a one-income lifestyle, you may have to make a few sacrifices. For example, if you bought your home based on your combined income, you may want to reevaluate your living arrangements. This is one of the reasons our family relocated to North Carolina. Although we enjoyed living in California, we simply could not cover our fixed expenses on one income.
Sign #3: You live in your 30s like you did in your 20s, 40s like you did in your 30s, your 50s like you did in your 40s, and so on.
Now when I first read this I was a little worried, because there were things I was doing in my 20s that I should NEVER be doing in my 30s (or any other time for that matter, but I digress). Upon further explanation, what this goal is trying to say is live financially as though your income did not go up. For example, in my first job out of college, I made $30k a year. By the time I was 30, I was making around $50k a year. If I understand this sign correctly, I should be living as though I still made $30k a year and saving the rest. Yeah, right!
By the time I hit 30, I was married with two kids—I needed the extra income—but I understand the premise. If we can resist the temptation to raise our standard of living with our income, there’s a much higher likelihood we’ll be able to maintain our desired lifestyle throughout retirement. It’s a simple matter of delayed gratification.
Sign #4: You have only one car payment at a time, or better yet, you save in a car replacement account each month instead of making a payment.
It usually works something like this: You need a new car, so you go to the car dealer and the first question the salesperson asks you is “What kind of payment are you looking to make?” Americans have been conditioned to believe car payments are a way of life, but most financial experts agree that financing a depreciating asset is not a good idea (even when there is 0% financing). Just about all of us need a vehicle, so how do we get one without a car payment attached?
It’s rather easy, really. Decide when and how much you are willing to pay for your next vehicle, and start saving for it. If you already have a car payment, you’ll just have to wait a little longer, that’s all. For example, let’s say you have a $300 a month car payment over the next six years. When six years is up, keep making the payment, only start making it to you. After four or five years, you’ll have a nice “car replacement” account you can use to buy your next vehicle (and I don’t mean a down payment). This may mean keeping your current vehicle running longer, but most experts agree that is cheaper than buying a new car every time the old one is paid off.
Sign #5: Your home’s value is 2 to 2.5 times your income and your mortgage is no more than 80% of the value.
You probably already know that the best terms on a mortgage are generally offered to borrowers that are able to come up with at least a 20% down payment, but not many home buyers (including me) are familiar with the 2 to 2.5 times your income rule of thumb. Instead, many potential home buyers are encouraged to buy the largest house they can afford, but what the lender thinks they can afford may be different from what they actually can afford.
As a rule of thumb, your housing payment (including principal, interest, taxes and insurance) should not exceed 25-28% of your gross income. Also, don’t convince yourself that you can afford a higher payment today because of the prospect of higher income in the future. I know too many households that bought that line only to end up struggling to make ends meet.
Sign #6: You have a will.
Whether you hire an estate planning attorney, use the legal benefit offered through your employer, or write your own will using will preparation software, everyone should have one. It is one of several basic estate planning documents, along with a durable financial power of attorney, living will, and healthcare power of attorney, that a financially healthy person should have as part of their estate plan.
Sign #7: You give at least 5% of your income to charity.
You know you’ve conquered the financial giant when you can share your wealth with others. Some would even argue that charitable giving can actually improve your finances. Whatever your motivation, when you give, give cheerfully.