When thinking of your personal finances, do you feel like you have margin to build wealth, pay down debt, and be generous? Or do you feel like no matter how much you earn you struggle to get ahead?
No matter which you relate to, you should be aware of a metric that is important to moving forward in your finances.
Burn Rate is one of the 12 scores called “Elements” that compose the Elements Financial Planning System. These are a series of financial indicators you can use with your advisor to see how financially healthy you are.
What is “Burn Rate”?
Burn Rate is the percentage of your gross income being spent on personal living expenses. However, we think it’s important to separate debt payments and calculate these independently.
For example, if you earn $15,000 per month and spend $10,000 ($2,000 of which is your mortgage payment), your Burn Rate would be 53.3%:
$8,000 / $15,000 = 53.3%
This means 53% of what you earn is being spent–or burned–on living expenses.
Why is Burn Rate important for you to know?
It affects your ability to save, give, and pay down debt.
There are only five places your money can go:
- Saving
- Spending
- Debt
- Taxes
- Giving
Knowing your rate for each of these Elements helps you answer the question, “Am I using my income wisely?” The higher your Burn Rate, the less money you will have available to save, give, and pay down debt.
It determines how much life and disability insurance you should have.
Do you know how much life insurance you need? The correct amount is determined in part by how much your family spends every month. If your family’s expenses are higher, you probably need more life insurance.
What about disability insurance? The average Social Security Disability Insurance payment is only $1,234 per month. Knowing your Burn Rate helps determine how much disability insurance you should have. Chances are, Social Security Disability Insurance won’t be enough to pay your monthly expenses.
It informs how close you are to making work optional.
One of the most common questions we get is how much money is needed to retire. People are focused on the nest egg—their net worth—and not enough on the other part of the equation—their monthly expenses.
As explained here, monthly spending indicates retirement readiness more than net worth. This is why all people approaching retirement should know their Burn Rate. If you are serious about making work optional, knowing your Burn Rate is the first step.
How do I determine my Burn Rate?
If you aren’t currently tracking your spending, the first step is to estimate your monthly spending. Be sure to subtract monthly debt payments, as those should be captured as a separate Debt Rate.
It’s often said, “what gets measured gets managed.” This is also true of your spending. While estimating your monthly spending is fine at first, it’s important to implement some sort of tracking system.
Notice I didn’t say, “You need to budget.” As I’ve written about before, budgeting isn’t necessary for financial success. But, I think everyone needs to periodically track their expenses over two to three months to get an idea of where their money is going. This can be done through a budgeting app or a simple spreadsheet.
What is a “good” Burn Rate?
Finding a metric for what constitutes a normal or healthy Burn Rate starts with your income. Someone with a lower annual income will likely have a higher Burn Rate than someone with a higher annual income:
- Under $100k: 50% – 70%
- $100k to $250k: 45% – 65%
- $250k to $500k: 40% – 60%
- $500k and up: 30% – 50%
Other factors that affect your Burn Rate include the size of your family, the cost of living, and your age.
Wrapping it up
Burn Rate is an important metric to know. Your retirement readiness, amount of insurance you should have, and your ability to save and pay down debt is all determined by your Burn Rate.
Start by estimating your monthly expenses, then take a few months to track expenses to get a more accurate number. This number can change over time, so it’s a good idea to track your expenses every year.
