I witnessed a mini-scandal recently when a recently-divorced 34 year old colleague brought his new 23 year old girlfriend to an event. He thought it was fine- they were both adults and she had just graduated from university. Others disagreed, arguing that it was a clear violation of the undisputed rule of inter-age dating, the “Half Plus Seven” rule. Under this clever formula, the youngest permissible age to date is half your own age plus seven, meaning that he couldn’t date anyone younger 24. For you Excel geeks out there, the rule is if(partner age<((your age/2)+7), gross, cool).
In the world of personal finance there are all sorts of similar formulas, ranging from useful rules of thumb to iron clad metrics. For example, there are standard formulas used by banks when you go looking for a mortgage- usually they say that your monthly mortgage payment shouldn’t exceed 28% of your gross monthly pay, and your total debt payments should not exceed 36%. Sounds simple, right? It is, but it’s also pretty generous, as 28/36% of your your gross income could easily translate into 46/60 of your net income, leaving you with not a lot of money to spend on necessities like food and high definition cable channels. It also fails to account for the total debt load, focusing instead on monthly payments. You can spread just about any debt out over a long enough period to fall within this guide (see the number of 30, 35, and even 40 year mortgages), but that doesn’t mean it’s a particularly good or financially responsible idea.
Rather than focus on monthly payments, I’ve heard some folks use annual income as a benchmark for how much one should plan spend on big ticket items. I once heard a real estate agent suggest that 2x gross annual income was a reasonable amount to spend on a house, but I’ve also heard numbers ranging from 1x on the conservative side to 3-4x (!!) on the more generous side. There’s no real science or reason to these numbers beyond social expectations and fuzzy logic, but they sure do get bounced around a lot.
Things are equally divergent when it comes to spending money on a car. In a recent post about purchasing a car, a commenter suggested to Frugal Trader that he should spend no more than 10% of his gross annual pay on a car- that is, if he makes $50,000 a year, he shouldn’t drop more than $5k on a car. Similar formulas popped up in two other blog posts last week- Stephanie from Poorer Than You mentioned 10% of gross as a guide for monthly car expenses in her post about how much you should spend on a car, while Tomasz Gorecki took the idea further in response, suggesting buying a car worth no more than 10% of your gross. This was the first time I had heard this particular rule, and suddenly it seemed to be everywhere I turned. It’s a figure that is as valid as any other, I suppose, but I haven’t been able to find any real basis for it. In my circle of gearheads, the numbers I’ve heard kicked around are significantly higher, with some people saying to spend up to an amount equal to your annual salary on a car. If you plan to sleep in it that might be okay, but otherwise I can’t help but think it’s more than a bit of a stretch.
The problem with any sort of formula like this is that it looks at only two factors to make a determination- your income, and either the overall cost of the asset or the monthly payments, and in doing so misses the many other variables that come into play, including your net worth, other assets, other debts, and in the case of monthly payments, the total obligation. Some who owns his own home and has ample savings may be able to reasonably spend 1x or more of his annual income on a new car without feeling any pinch; similarly, for someone with significant debts and no assets, even 10% on a car could be a strain. Such formulas also assume income as a measure of financial means, although this is not always the case. A diligent saver has much more flexibility than someone living beyond his or her means- both may make $50,000, but that doesn’t mean that both are in a good position to buy a $30,000 car or a $200,000 house.
My purpose in this post isn’t to promote or dissect these formulas. Instead, I’m interested in hearing what other type calculations or guides are out there. Do you have any rough guidelines that you use when purchasing big ticket items? What are the best and worst financial formulas you’ve ever heard?
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Fact 1
Knowledge is Power
Expressed mathematically: Knowledge = Power
Fact 2
Time is Money
Expressed mathematically: Time = Money
Fact 3
From physics, Power = Work / Time
So now we just replace a few terms. 1) Replace Power with Knowledge. 2) Replace Time with Money:
Knowledge = Work / Money
Remember, Knowledge IS Power and Time IS Money.
Or written more cleanly: Knowledge = Work / Money
Solving for Money, we get: Money = Work / Knowledge
Therefore, Money approaches infinity as Knowledge approaches zero, regardless of the amount of Work done. Perhaps this explains why executives at failed institutions are still making the big bucks!
Preet, that could be the funniest math equation I’ve ever seen, and that’s saying something!
Huh. Guess it’s gross for me to be dating MY BF then huh?
We are blowing that stupid formula out of the park w/ our ages… Me being v. young and him being older.
FB, as long as you’re happy I’ll promise not to tell the rule makers.
You are absolutely right. Acquiring the asset is one thing but maintaining it is even more important.
When you buy a car, you drop a few thousand right on the spot. But maintaining it is done over the life of the asset which may be years. So you have to factor in your time, energy and of course costs.
I would agree with the end of your post that it is hard to apply formulas across the board, as people’s savings habits would better determine their ability to take on the so-called “big-ticket item.”
I would also say that spending one year’s gross annual income on a car is ridiculous.
A very thought-provoking article, thanks.
I’ve heard these suggestions:
2 times your salary on a house
Half your salary on a car
2 weeks salary on a vacation
2 months salary on an engagement ring
I have no idea where they come from, but I hear them alot. The house sounds too low, and the ring sounds too high, but the vacation sounds just right!
2 times your salary on your house as a MAXIMUM?!? That might have been an okay rule in the 1970’s, but not today. If it were, only the wealthy could be homeowners. In most major markets, you can’t find a house for under $250k. 3-4 times is a much more reasonable number even after the housing collapse.
2 x salary might work in Newfoundland, but not in any big city.
My personal favourite. . .
(sauce 4 goose) = (sauce 4 gander)
OK - full disclosure: After the initial paragraph about hooking up with a 23 year old, I pretty much only skimmed the rest of your post. So I can’t comment on anything else you wrote, but when it comes to 23 year olds, here’s my formula:
1+1 = Now
Interesting question. I myself am drinking the Dave Ramsey Kool Aid. In our household we will only buy cars with cash, not with payments.
Depending on when emergency fund is fully funded, and we have no debt, whatever may be left in cash savings is what we use to purchase cars. Used (gently) cars at least 4-5 yrs old.
A car is a depreciating asset. A brand new car will on average lose 70% of its value in the first 4 years. Regardless of the 0% interest “deals” out there, at the end of 48 months you’re still making payments on an asset that’s lost 70% of its value! (On a brand new car).
The answer is a company car.
LOL. I am still on the half + 7 rule. My DH beats it by just 3 years with me.
Never heard that rule, that is interesting.
I think you have to have a general formula to meet the masses. You cannot personalize a rule for every person. There is just to many people vying for the same attention in financial matters.
The funny thing is that if no one spent more than 2 times their income on a house, you could do that and still get a nice house with an average salary because no one could sell a house at a higher price. Unfortunately it seems like a lot of people are relying on dual incomes, taking/keeping higher-paying jobs that they don’t like, and gambling against anything bad happening in order to support all their spending, so sometimes you have to follow them at least a bit or be priced out when they’re ready to spend 4x their income (or is it 8x in vancouver?).
My little contribution to this (continuing the relative effect) is to borrow far less than the average person, invest far more, and avoid spending any money that I can think of a better use for. Hopefully a modest difference at first adds up quickly
Other than that I don’t have much use for rules right now (other than a recent increase in my automatic investments to bring them up to a decent percentage of my income) because I can compare the options and pick something that’s worth the cost to me.
Eventually I expect to spend more than I really think is necessary on housing since that’s something I enjoy, but stick to cheap cars (I barely use it anyways) and not go out frequently (now that I can cook things that are just as good as any ordinary restaurant).
If your credit score is 680 or greater CHMC will let you have a TDS of 44% and there is no GDS to consider.
If you have paid off your vehicles, credit cards, loans and have no other debts CHMC says your housing costs, mortgage, taxes and heat can eat up 44% of your gross income.
Evaluating this a little further a person or couple could buy a $500,000 home with 5% down, amortize it over 35 years with a yearly income of less than $70K.
Wow, is all I can say.
Unless it is your house or your car, I rent almost anyhing I can’t buy for under $1000. I don’t own a boat, a vacation home or a jetski…I rent them.