Amy sat at her desk, looking at her completed tax form. “If I made that much last year, why don’t I feel like I ever get ahead? I watch all the little ‘leaker’ expenses the way I’m supposed to. What’s wrong with this picture?”
While Amy’s right in being concerned that money can slip away through small “leaker” expenses, in truth it’s the big life expenses that determine if we’ll make it or break it.
They are all related to specific decisions you make … but all too often they’re made without really considering the true financial implications. They include where you went to school, what you drive, where you live, how many children you have and how you’ll retire.
So how does that work?
Well, some financial advisors figure we’ll spend over half of everything we earn in our entire lifetime just on those five things!
Your College Education
A college education isn’t translating automatically into a well-paying job any longer, so college debt needs to be taken on carefully. The rule of thumb here is that your total loans shouldn’t exceed the average annual income you expect to earn in the first ten years out of school. So, $45,000 average income? $45,000 in total school loans. $75,000 average income? $75,000 in total school loans. This means you’ll be paying 10% of your annual income each year, over ten years, in order to repay that debt.
The general rule is that your car shouldn’t cost more than one-third of your annual income. So if you make $100,000 a year, you should be driving no more than a $33,000 car. (If you think of how many people making $40,000-50,000 a year are driving more than $13,000-17,000 cars, you can see how quickly things get out of hand.) Your car carries other expenses too. In short, the total monthly expenditure for your car (including car payment, insurance, registration, parking, fuel and servicing) should hover around 10% of your monthly gross income.
Here the rule is the reverse: the rule has always been that the price of your house should not be more than three times the annual income of all contributing earners in the home. So if you make a combined $100,000 a year, you should be living in no more than a $300,000 house. But varying mortgage interest rates and property taxes leave some flexibility in that rule. In any case, the total monthly expenditure for your house (including mortgage payment, insurance, property taxes and general maintenance) should hover around 30% of your monthly gross income.
The Department of Agriculture publishes numbers each year on what it costs to raise a child. The latest publication, for children born in 2012, says that a middle-income family can expect to spend about $241,080 (or $301,970 adjusted for projected annual inflation of 2.5%) for food, shelter and other necessities associated with child-rearing over the first 17 years. Second and third children cost a little less. But that’s before college. (Note: some of the shelter costs are already covered under “Your House”.)
Lots of different “rules” exist for this one. One rule of thumb is that you’ll need 25 times your current annual income in order to maintain the same standard of living when you retire. That means that, if you’re at $60,000 annual income, you’ll need $1.5 million saved by retirement. Inflation, interest rates and typical investment earnings all wreak havoc with this kind of calculation, but the rule of thumb at least gives you a rough idea of the magnitude of savings needed.
The Big Life Expenses Challenge
Not all big life expenses are incurred at the same time. But look at the figures: 10% of your gross income for school loans, plus 10% for a car. (Or do you need two cars once the kids come along?) Then 30% for the house. Plus each child at nearly $250,000 (plus college). And retirement? If you saved from age 25 to 65, you’d have to average $37,500 in savings, interest and earnings each year for the example we gave.
And all of this is before you pay your taxes.
While these numbers look scary, the purpose is not to frighten you. Instead it is to be sure you make each of these decisions conscientiously, understanding that the lion’s share of the money you’ll be spending over your lifetime will go towards big life expenses.
Only after that can you start worrying about the little “leakers” that make it easier or harder to close out each month.
Let us know in the Comments section below if you realized how much of your annual expenditures were wrapped up in so few decisions.
Bio: Sharon O’Day fixes financial lives. She is a tell-it-like-it-is money expert with a successful career in global finance, plus an MBA from the Wharton School. Today she specializes in getting entrepreneurial women over 50 back on their game so they can have more money, less stress and more joy. With her “Over Fifty and Financially Free” strategies, they take actions that lead to their ultimate goal: financial peace of mind.