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Personal Finance
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Save this, spend that: The real 'rules'
Financial rules of thumb almost never specify gross or net income; nor are they one size fits all.
July 16, 2004: 10:57 AM EDT
By Jeanne Sahadi, CNN/Money senior writer

NEW YORK (CNN/Money) You've probably heard the "rule" that an engagement ring should cost about two months' salary. Whether you buy into this notion or not, you still might wonder, "Well, gross or net?"

In fact, that's a good question to ask about any number of financial rules of thumb. After all, there's a big difference between your salary on paper and your take-home pay.

If you make $60,000 a year, you gross $5,000 a month. But you take home considerably less after taxes and other payroll deductions such as 401(k) contributions and insurance premiums are taken out.

So we've decided to set the record straight on some common money guidelines that pertain to housing, debt, emergency savings, getting rich, and yes, the all-important diamond ring.

We also want to set the record straight on rules of thumb in general. They're interesting as general yardsticks. But they really don't take into account your full financial picture, including your priorities, your obligations and your debts.

"One size doesn't fit all," said certified financial planner Barbara Steinmetz.

So, how much to spend on a rock?

We took an informal survey around the office and, interestingly, most of the women thought the two-month rule referred to gross salary, while most of the men thought net.

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The two-month rule, remember, is most handy for those in the jewelry and wedding industries, who profit from the pressure on grooms-to-be. But it's not an awful guideline for someone who'd otherwise be lost when it comes to buying jewelry.

So, are we talking two months' gross or net? It turns out the men are right, at least according to the The Knot.com, the wedding advice site. "We feel it's net. It's what you're bringing home that you can afford," said editor-in-chief Carley Roney.

Ultimately, of course, the only amount you "should" spend is what you decide you can afford. If you have $20,000 in credit card debt, it doesn't really make sense to spend two months of income, gross or net, on jewelry, Steinmetz said.

How much to spend on housing?

So much depends on the cost of housing where you live, what your priorities and obligations are and what financial sacrifices you're willing to make to pay for your home, Steinmetz said.

What may work for someone starting out may not work for someone raising a family or on the verge of retirement.

Having said that, ideally, you don't want to spend more than 25 percent of your gross income on housing payments. You may, however, be able to spend a little more on the mortgage than on rent, because you're likely to get some of it back in income-tax deductions.

How much debt can I have?

Less is always better, of course. But the question becomes relevant when you're shopping for a loan and want to get the best rates.

To qualify for the best loans and still keep your head above water financially, you might apply the traditional mortgage bankers' rule: your total monthly long-term debt payments -- including your mortgage, credit card payments and loan payments -- should not exceed 36 percent of your gross monthly income.

But again, you may need to trim one part of your budget (or better yet, avoid non-housing debt altogether) in order to spend a little more on your home, depending on where you choose to live.

How much do I need for emergencies?

The answer in terms of your income is neither gross nor net. Ideally, an emergency fund should cover three to six months' of expenses. Those expenses include housing, utilities, food, loan payments, etc.

They do not necessarily include the amount you're saving pretax or after tax while collecting a paycheck, Steinmetz said.

So if you net $2,700 a month after taxes and 401(k) contributions, but only spend $2,000, your emergency fund should have $6,000 in it ($2,000 x 3).

How much should I save to get "rich"?

You often hear that people who become millionaires by saving diligently put away between 15 percent to 20 percent of their income every year.

In this instance, think "gross income."

So if you make $100,000 a year, that means saving $15,000 to $20,000 a year.

Ideally, a good portion of that should go into a tax-deferred vehicle such as a 401(k), since money that grows tax-deferred compounds more quickly than money invested in an account that gets taxed every year.

But if you plan to save $20,000 and you max out your 401(k) -- the federal limit is $13,000 this year for those under 50 -- you'll have $7,000 left. Chances are, you won't be able to stick that in another tax-deferred vehicle before your paycheck is taxed. So, in effect, you'll have less than $7,000 to invest.

Ultimately, how much you should save every year is completely dependent on your goals, your time horizon and the assets you've already accumulated. Once you've worked that out, your focus is not about percentages.

"The dollar amount is your target," said certified financial planner Jon Duncan.

(For help with your dollar target, try our Millionaire in the Making calculator.)  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.