This piece was originally published on Beyond Your Hammock
Personal finance doesn’t need to be overly complicated. Yes, the complexity in your financial life will increase as you build assets and grow wealth — but don’t confuse complex for overly elaborate and impossible to understand.
At the end of the day, most of what it takes to reach (and maintain) financial success comes down to some fairly simple principles.
When it comes to knowing how to better manage money, in fact, you only need two rules of thumb to keep you on track.
Following these guidelines will help you keep your cash flow under control while also ensuring you leverage your income today to grow your net worth well into the future.
First, Make Sure You Work with the Right Priority List
If you want to know how to better manage money, you need to start with your priorities.
What are your priorities? What really matters to you? These are deceptively difficult questions. Everyone thinks the answer is obvious, until you need to give a very specific response.
So ask yourself: If you could only name one thing as an ultimate financial goal, one thing you could accomplish with your money… what would it be?
Make a list of what you want, and be honest with yourself. Your list could range from material things to experiences to values you want to live out, to massive financial undertakings like building up enough wealth to leave an inheritance or to reach financial independence by your mid-40s.
It’s okay to have multiple goals. The point here is to get clear on how those goals may rank. The only way to do that is to definitively put something in the #1 spot as the most important thing to you. From there, you can continue on to number two, three, and so on.
This is, to put it lightly, challenging. In our financial planning work with clients, we find it helps to ask the question, “If I could only do/have one of these things and none of the others, what would it be?”
Each time an item is selected, it gets the next number on the list. Continue down your list this way until you have a priority-ranked list of goals.
When you finish this exercise, you’ll have a clear list that says, “this is what matters most to me.” With this clarity, we can get into the numbers and the objective strategies for savings and spending plans.
Everyone has different preferences, and it’s important to identify yours. It’s also the very first secret to knowing how to better manage money.
When you know what matters, by default, you also know what isn’t as important. Identifying your priorities and what is most important to you gives you a clear roadmap for what it makes sense to spend on, and what you know you need to save to get more of what you want.
Then, Use These Two Metrics to Understand How to Better Manage Money
For most people, some version of the goal “retirement,” or “financial independence,” or “make work optional by X age,” tops the list of their financial goals.
However that looks to you, or however you articulate it, almost everyone aspires toward reaching a point where they don’t need to rely on earned income to fund their lifestyles.
It makes sense that this would be the number-one goal for most folks (who aren’t already independently wealthy, anyway). If you can achieve it, it means you have more choice, freedom, and flexibility to spend your time how you want, where you want, and with who you want.
If that’s not financial success, what is?!
It also points to the most critical rule of thumb to use when you need to figure out how to better manage money: success starts with what you save, not what you spend.
Just like you need to give a priority-order ranking to your goals, you should also consider the order of operations to actually achieving them. And having and investing money are two of the most important actions you can take if you want to grow your net worth.
So let’s start there with the first rule of thumb you need to learn how to better manage money.
Rule of Thumb #1 for Better Money Management: Save (At Least) 25 Percent of Your Income
The beauty of starting your money management with savings in mind is that, once you address that need, you’re free to spend whatever you have left on whatever you want. You can spend without guilt, and without worries over “but am I saving enough?”
If you start with savings and use our rule of thumb for how much to save and where, then you can have some confidence that you are in fact on track to have enough.
Specifically, that rule of thumb says that 25 percent of your gross income needs to go to long-term investment vehicles. Let’s break that down a little to clearly understand what it’s telling us.
Say you make $250,000 in annual gross household income. 25 percent of that is $62,500. If you follow this rule of thumb, that means you need to contribute at least $62,500 to long-term investments by the end of the year to get to an annual savings rate of 25 percent.
By “long-term investments,” we mean investment accounts designed to help you grow wealth over time. These could be any of the following (and usually a combination of):
- Retirement plans, like 401(k)s or 403(b)s
- Retirement accounts like IRAs (of any kind: traditional, Roth, SEP, SIMPLE)
- Health savings accounts, assuming you invest your contributions and don’t spend them on current-year healthcare expenses (here’s why we advocate for this strategy for healthy folks who don’t expect big medical bills in the short-term)
- Employer stock purchase plans (assuming you periodically sell shares of company stock and reinvest the proceeds into a diversified investment portfolio)
- Taxable brokerage accounts
This is money designed to help you increase your net worth and build assets over time, which is why only the cash you contribute to investments for growth (rather than cash savings that you plan to spend this year or shortly after) count toward your savings rate for the year.
Why 25 percent? Because we find this is the baseline to give you a good to great probability of success over the long term. If you contribute 25 percent of your income to vehicles like retirement plans and brokerage accounts (that you don’t plan to access for 10 or more years), you give yourself better odds of building assets that will last over your lifetime.
However, this is just a rule of thumb. And 25 percent is what we consider the baseline, or the starting point. Your specific circumstances or exact goals will ultimately determine if this number is appropriate for you.
If, for example, you have a pension that will provide you with sufficient income in retirement or your family has a trust fund that you can rely on in the future, then putting 25 percent into long-term investments might not actually be necessary for you.
The same could be said if you’ve saved aggressively (like putting away 30, even 40 percent of your income into investments annually) for the past decade. In this case, if you wanted to back off that high savings rate, you may be able to without jeopardizing your financial goals or future stability.
On the other hand, 25 percent may not be enough if you want to make work optional by a certain age; the younger you want to stop relying on an income, the more you need to save and invest now to build the assets that will support that goal.
Or maybe you got a late start on saving in general. In that case, you might have to do more heavy lifting now to get caught up to where you need to be.
The bottom line here? We’ve seen the 25 percent savings rate work for a lot of people… and we regularly tweak that recommendation for specific clients whose situations call for a different approach.
Use this as a starting point, but always work to develop your own personal financial plan that meets your needs in the context of your life.
Rule of Thumb #2 for Better Money Management: Limit Your Spending on Housing Costs to No More than 20 Percent of Your Income
Once you address the need to save and invest — which all of us need to do, regardless of our specific goals or desires — you can then turn your attention to the other side of the cash management coin: spending.
This is where learning how to better manage money can go off the rails. It is hard to push yourself to save more. It is very easy to spend… and spend, and spend. And there is probably no bigger expense category in your budget than the line item for housing.
Whether you rent or own, you gotta live somewhere — and the cost of your housing situation, whatever yours may be, is likely going to represent the biggest chunk of spending that you do in in any one area of your life.
That’s why our second rule of thumb to answer how to better manage money revolves around managing this fixed expense.
We use a percentage of gross income as a benchmark for determining home affordability for our clients. Specifically, our guideline is that, ideally, your housing costs should not exceed 20 percent of your gross household income.
We define “housing costs” as not just your mortgage payment, but also your taxes, insurance, and maintenance or upkeep (which we usually estimate at an annual cost of 2 percent of a home’s value, on average).
If your total housing costs are 20 percent or less of your gross household income, we consider that an affordable home for you.
Is there wiggle room here? Absolutely.
Just like the 25 percent savings rate provides a baseline starting point subject to change (either up or down) based on your circumstances or goals, the housing cost benchmark works the same way.
If housing is a particularly low priority to you, then spending one-fifth of your gross income on this area of your budget might be far too much. You may be better served by keeping your spending on housing to something like 15 percent of your income.
(This may be easier to do, by the way, via renting than buying, depending on where you live and your lifestyle. Your mortgage payment is the smallest amount you’ll ever pay per month for housing. Your rent payment is the highest you’ll likely need to pay, since someone else deals with taxes, maintenance, and repairs.)
Or, maybe your home is wildly important to you. Having a specific home in a specific location may be the second-highest priority you have, right behind being able to retire when you want.
If that’s the case, spending a little more — say, 25 percent of your income — on your housing may be the right choice for you.
We came up with 20 percent as our baseline because our clients are in their 30s and 40s, and while almost everyone wants a very nice home, they also want to do more than just own a specific house and sit in it all day.
They have really big financial goals, want to grow their families, start businesses, or change careers — all of which may be harder to do with more than 20 or 25 percent of gross income going to a single, massive fixed cost.
All of these transitions and milestones mean you need to have available cash flow to either handle higher expenses in your budget outside of your rent or mortgage payment, or you need to have enough money left over each month to contribute to savings and investments to achieve big goals.
By setting our rule of thumb for capping housing costs at 20 percent of gross income, it means you give yourself plenty of room in your budget for other spending, necessary savings, and different goals that may be just as important to you as buying and owning a home (or maintaining your ideal rental situation).
If you max out on what a realtor or lender says you technically can afford, you may be able to pay your mortgage payment each month… but not have much else left over for anything else, and financially limiting yourself isn’t a good way to go if you want to grow wealth and use your money for other priorities in life.
Why These Rules of Thumb Improve Your Money Management
These guidelines can provide you with a great starting point for understanding how much you need to save, and what’s appropriate to spend on one of the biggest expenses you’ll have throughout your life.
They work well because they are percentages of your income. They can (and should) adjust as your earnings change. This keeps both your savings and spending relative to what you make as you make it.
These rules of thumb are also good because they’re simple. They’re clear and easy to grasp; using these will give you clear, objective answers to often difficult questions like “how much do I really need to save?” and “can I truly afford this?”
If you can implement these rules in your own life, then you’re also very much free to use the rest of what you earn however you’d like. It’s one major way you can truly master how to better manage money.
You don’t need to worry if it’s “okay” if you spend $10,000 on a major trip. Can you still save at least 25 percent of your income each year? If yes, then of course it’s okay. It’s your money; use it in a way that aligns with your values.
Similarly, you don’t have to question whether a house is “in your budget” or not. Will your all-in housing costs exceed 20 percent? If no, you can probably afford it comfortably. If the costs will go over 20 percent, dig in deeper: Will spending more limit how you can use money in other areas of your life, and is that okay with your or not? Will you need to have room in your budget for other big expenses (like adding children to your family), and does a house that eats up more than 20% of your gross income prevent you from doing so?
These guidelines can give you clarity on what would otherwise feel like totally overwhelming, very emotional financial decisions, which is probably their greatest benefit. They provide a way to ground yourself rather than being swept away by how you feel about your finances.
The downside of that is that, yes, they do lack nuance. If you apply these to your own life without question, you may find they’re not a perfect fit — so please do consider them with a critical eye before following them.
Use these guidelines as just that: guides, rather than a precisely-marked path labeled “the right way.”
The challenge with personal finance (and with so much else in life) is that while the numbers themselves may be objective when they’re in a software system or spreadsheet, they become extremely subjective in the context of your real life.
Good financial planning addresses that reality by custom-fitting you with an action plan that makes sense in context. There is no one right answer or strategy. There’s only what suits you and your life best.
These rules of thumb for spending and saving can help give you a clear answer to how to better manage money. But it’s only the first answer that can help you develop the right habits for success. Don’t hesitate to keep exploring, keep asking questions, and keep seeking out the knowledge you need to construct a highly customized plan that works for you.
Need help getting started with the right strategy for you and your situation? Learn more about our financial planning programs at BYH.