How much should I Spend on Housing and Debt Repayment?

One of the first questions I’m asked when I prepare a financial plan is how much should I be spending?

Understanding your cash flow – the cash coming in and going out each month — is the most important part of any financial plan. Some of my clients are really good at knowing this information, while others have no clue how much they spend or where they spend it. A key gauge is whether you have money left over at the end of the month.  If you do then you have positive cash flow.  If you don’t then you are likely to have negative cash flow.

I use three statistics to get a quick picture of a client’s spending.  These three statistics are just an on-ramp to understanding your cash flow. They are not set in stone in every case, but rather guideposts that can help identify pitfalls or opportunities.

Housing Costs

First, I look at your monthly housing costs as a percentage of your monthly gross income. For many folks, housing costs include either rent or mortgage payment. If you own your home, I include property taxes and homeowners’ insurance. If you live in a condominium, I add any condo fee because these expenses are related to your housing choice. A recommended guideline is 28 percent, meaning that your housing costs should not exceed 28% of your gross income. A few years ago during the housing crisis, folks were buying homes in which their monthly housing costs would be more than 40% of their gross income.  It doesn’t take a genius to figure out that this situation was not sustainable.

Total Debt Payments

I next look at all of your debt payments to your gross monthly income. I consider not only your housing costs (i.e., rent or mortgage payment), but also other monthly debt payments such as car loan payments, student loans, monthly credit card payments, and any personal loans. The recommended guideline is 36%, meaning that no more than 36 percent of your monthly income should go to housing debt costs.

In the DC area, however, housing can be expensive.  As a result, some folks have a mortgage payment that may be higher than the 28%, but lower than 36% because they have no other debt. This situation can be fine. In other situations, student loan debt can be very high such that total debt is beyond the 36% recommended level.  But this situation may be okay if there are only a few years before the loans are repaid and there is sufficient cash for living expenses.  The same principle applies to other debt such as wedding debt or a personal parental loan for a home down payment. If the expected duration is not long of high debt payments there usually isn’t anything to worry about.

Savings Rate

The third measure is your savings rate – how much money you are putting aside in a separate account for long-term savings. A recommended guideline is 20 to 25 percent of your gross monthly salary. So if you make $10,000/month, about $2,000-$2,500/month should be going to savings. Contributions to your retirement plan at work as well as any matching funds your employer provides count toward this goal. This level may sound high, but if you want to have a secure retirement or buy a home or build an emergency fund – this is the right level to keep you on track.

The important thing is how much money is left over after your housing costs are paid, the debt payments made, and the savings saved.  If there is plenty of money left over for food, entertainment, shopping, travel and transportation then you are in good shape even if your total debt payments are more than 36%. But if you aren’t putting enough away for savings, then you may want to look at reducing your spending.

There are many online tools, such as Mint and LearnVest, which can help you quickly identify problem areas. Or you can keep track of everything you spend using a pen and a piece of paper. In either case, I suggest that you classify your monthly spending in three buckets – debt payments (mortgage or rent payments, student, car, or personal loans), fixed expenses (such as utilities, cable, cellphone, Netflix, day care, subscriptions, insurance, and any other recurring monthly charge) and living expenses (such as food, entertainment, travel, shopping, car repair, and all the rest). You can then look to see the expenses that may be higher than you want them to be and you can work to reduce them.

In sum, ask yourself three questions:

1. How much are your monthly housing costs as a percentage of your monthly gross income?
2. How much are your total monthly debt payments as a percentage of your monthly gross income?
3. How much are you monthly savings as a percentage of your monthly gross income?

The answers to these three questions will give you a good picture of your spending.  Moreover, the answers will form the foundation of your financial plan.

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