It's really quite simple. We all have to live within our means unless we want to end up with bills we cannot pay.
And we actually also have to live beneath our means and find ways to save and put money aside if we have any hope of ever achieving financial independence one day – or even of retiring.
That’s the economic reality, regardless of income level. And a budget helps us establish control over our finances to accomplish just that.
That point really cannot be overstressed, and it never changes throughout our working lives. Savings are not only an essential in any household or personal budget plan, they are the main reason for creating one.
A budget gives us a road map for achieving those savings as well as overall financial health.
It also shows us when we need to make adjustments - by increasing income with a part-time job, for example, or cutting expenses in some areas - if we happen to be falling short.
Now, in order to accomplish those savings, we have to make choices about how we spend our money.
Very few of us have the luxury of buying and doing everything we want and still remaining on sound financial footing.
Setting a budget also helps us in this regard, by making us focus on what's essential and what's not when making those decisions.
A budget pushes us to be more intentional in our habits by having us think about the allocation of our hard-earned dollars and consider where they are needed most and where they would have the most impact on the quality of our life, the goals we’ve set for ourselves, and the things that mean the most to us.
Some of those goals may change over time, from paying off student debt, to saving for a used car, to saving for the down payment on a house, etc.
But some financial goals never change.
By that I mean that we always need an emergency fund for unexpected expenses; we always need to be saving for retirement; and we always need to be saving for that proverbial "rainy day" when life throws us unexpected things like unemployment or a serious accident or illness.
Living on a budget helps us build up a safety net that will enable us to weather even the most unwelcome, unexpected, or unfortunate circumstances without bankrupting ourselves.
Without a budget, chances are, your finances are mostly guesswork.
To create a budget, the first step is to know how much money you have to work with. That dollar amount will determine what you can afford to spend and still meet your obligations, including savings for yourself.
I always use net monthly income as the starting point of any budget plan, and then determine from there what I can manage to spend on necessary monthly expenses and still save adequately.
Net income is the amount you actually receive in pay after all the taxes are taken out. It’s also called “take-home pay.”
Some advisors start with gross income in determining a budget, and that’s fine for a very rough estimate, but I think that net income is a much more useful, realistic number for detailed budget purposes.
A Word about Independent Contractors
It bears mentioning that in this gig economy we now live in, many workers are not considered employees, but independent contractors, which means they are responsible for paying all their own taxes, including regular income taxes, as well as Social Security(FICA) and Medicare. If that describes your situation, then be aware that you must deduct those taxes before doing your budget.
Please note that the IRS has definite rules about who falls into this category, so be sure you're not being ripped off by employers - unintentionally, or otherwise - in terms of categorizing you this way.
It can have major impact on your bottom line if they are paying you as an independent contractor when they should be paying you as an employee. Any discrepancies should be pointed out to the employer or reported to the IRS.
This exact scenario happened to one of my sons, and his share of the tax bill was substantially higher than it should have been until someone reported the company to the IRS, and they forced the employer to do right by their workers.
Once you know your net income, you can apply some general rules of thumb in determining the maximum you can afford to spend in major budget categories.
Housing is one of them, for example. That is typically the biggest expense for most households, and my strong recommendation is to keep those costs to 25%, of your income if you can, and certainly to no more than 33%.
Of course, in this era of sky high rents, staying within those budget parameters for housing can sometimes be very difficult to achieve for those of you on the lower end of the pay scale.
But it's essential that you do everything you can to keep this cost to a reasonable level. If you're struggling with it, check out my blog about housing choices here.
Below are the other major, broad categories of essentials and some rough percentages or estimated dollar amounts that I recommend as a maximum monthly budget allocation for each.
Or as a minimum budget allocation --- in the case of savings.
TRANSPORTATION (including car loan + interest) – 8% - Remember, this is a maximum percentage, so less is better.
HEALTH INSURANCE – 10% - We don't have as much control over this as we'd like, but it pays to shop around to see which plan offers the right balance of up-front premium costs, or cost shares with your employer, deductibles, and total out-of-pocket expenses in the event of a major medical crisis.
OTHER INSURANCE (car, homeowner’s/renters, etc.) – 10% - Again, shopping around can help you find substantial savings.
FOOD - $100-$200 per person per month. There’s really absolutely no need to spend any more than this per person, regardless of how much money you earn, so forget percentages in this category.
You can use the lower budget number of $100 and cut your food budget to the bone with the help of websites like this one, or you can go for the higher budget number and have plenty of room in your weekly food allowance for indulgences on the weekly grocery run.
The bottom line is that there is simply no reason for anyone to ever spend huge amounts of money on food. Saving just $10 per week on your weekly food bill equals $520 a year. That amounts to tens of thousands over a lifetime.
That's something worth keeping in mind when you're shopping for food.
UTILITIES (electric, heating, cooling costs, phone, etc.) – 5% - There are all kinds of ways to save in this area, so it's important not to spend unnecessarily. Check out my related blog posts here and here.
SAVINGS/INVESTMENTS – MINIMUM 20% - It's my philosophy that this category should be the one that gets the most increases whenever you experience a rise in income. And that's before you increase the other categories (except perhaps loan repayments, as I explain below.)
After all, that's the whole point of a budget in the first place.
LOAN REPAYMENTS (student loans, credit card debt) - There’s no recommended limit on this. Paying off your debt should be a major budget priority once you have an emergency savings fund in place to cover unexpected expenses.
My own personal view is that you should pay as big a chunk of these every month as you possibly can after you have taken care of all your other expenses and your savings. The idea is to get rid of this debt as soon as possible.
And in the case of credit card debt, you should be paying way more than the minimum if you ever have any hope of paying it all off.
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I’d also just like to mention here that percentages in budget allocations only tell part of the story.
As I write in my blog about the 50-20-30 budget rule here, I would never recommend that someone making $250,000, say, should spend more on rent or a mortgage just because they can.
That’s a very silly approach to money, and a misguided philosophy that puts people on a consumer treadmill to nowhere.
It’s good to take note that one of the richest men in the world, Warren Buffett, still lives in the very pleasant, but hardly mansion-sized or grand home that he’s owned since his early days.
That indicates to me a wise man who understands that “things” do not bring happiness, and neither does the materialism that pushes even people of modest means to spend, spend, spend.
Your lifestyle does not and actually should not rise to meet your income.
So now you have a rough idea of the amounts you should be spending on big budget categories.
Now it's time to get a detailed list of the budget items to consider when you’re setting up your own household one.
Check out the itemized list below.
ESSENTIAL EXPENSES (NEEDS)
- Rent/Mortgage (including interest)
- Renter’s or Homeowner’s Insurance
- Real estate taxes (if applicable)
- Home/Yard Maintenance (lawn, snow removal, etc.)
- Loan Repayments (Student, personal, credit card)
- Groceries/Personal Care (including barber and hairdresser visits)
- Prescription glasses
- Child Care
- Car payment
- Gas for commuting
- Public Transit Commuting Costs
- Gas (Propane or Natural, if used)
- Oil (if used)
- Wood (if used for heat)
- Hot Water
- Water Usage and Sewer (if applicable)
- Phone (basic model and plan)
- Internet (yes, I do believe this has become necessary for functioning in today's modern economy.)
- Work clothes and shoes
- Emergency Fund
- Retirement Investments
- Additional Savings
But beauty and personal care is one area where it's mind-blowing how easy it is to get caught up in the hype about products and services.
It's very, very easy to spend way more than you need to on such extras -- that are most definitely NOT essentials -- as manicures and pedicures, expensive haircuts, treatments and coloring, fancy lotions, and expensive brand name make-up, etc., etc. The list is almost endless.
Be aware of those types of tendencies even in the category of essentials and of how much you are spending in each category, and how much -- if at all - those expenditures are adding to the quality of your life. You might be very surprised at how much you could save by being just a bit more mindful about these expenditures.
DISCRETIONARY EXPENSES (WANTS and LUXURIES)
- Beyond Basic Non-Work clothes and shoes
- Charitable Giving - yes, this is important, but only AFTER you have taken care of your own needs.
- Gifts - Many people fail to include this in their budget, but it can be a big expenditure in some households.
- Vet Bills
- Pet Insurance
Recreation/Entertainment/Leisure Activities and Associated Expenses
- Phones (higher end models)
- Phone Data Plans/Upgrades
- Gym memberships
- Lessons/Enrichment Classes
- Gas for leisure time travel
- Travel (tickets, hotels, Airbnb, car rentals, etc.)
- Restaurant/Take-Out Meals
It may be very surprising to note all the things on my list that I consider to be entirely discretionary.
But these items really are all wants, not needs. While people often become accustomed to thinking of certain things and activities as essential to their lives, they really aren’t, and it’s very important to remember that.
These are entirely discretionary for anyone, regardless of economic class or income. It’s just that they are even more of a luxury for those of us who have less discretionary income to work with.
So before you go about spending on even one of these items, be sure that your essential expenses are being met, and your savings plan is on track.
Once all that is in place, by all means go ahead and spend on fun stuff. Just do it judiciously and try not to develop expensive or lavish tastes.
It’s never easy to scale back down again once we’ve made things “necessities” in our lives.
Hold onto that thought and keep your “needs” simple. You'll be happier and healthier for it.