Planning

The 25% Rule to Budgeting

The 25% Rule to Budgeting :: Mint.com/blog

For most people, balancing personal budgets is a tedious and time-consuming process. These days, though, the task has become even more challenging.

According to the Federal Reserve, average household debt in the U.S. increased 5.25% during the quarter ending Sept. 30, which isn’t surprising given that annualized real (net of inflation) wage growth continues to be negligible: less than 1%, according to the Department of Labor.

Household budgeting is a zero sum game: there are only so many dollars to go around before savings accounts are drained and credit becomes scarce.

Too often, though, this fundamental tenet of good personal financial management is undertaken in hindsight—long after spending patterns become legacy, rents are locked-in and the debts are racked up. At that point, budgets feel more like diets than they do menus.

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Fortunately, there’s a better way to approach this task.

Start by dividing your before-tax income into four equal parts and grouping the daunting list of expenses your paycheck needs to cover into four categories: taxes, housing (rent and/or mortgage), debts (excluding mortgage payments) and living expenses.

The First 25%: Taxes

Face it, the money you earn is going to be taxed.

Between the various federal and local assessments (including Social Security and Medicare), figure on a bill that could total 25% of pretax income for moderate earners, particularly when payroll deductions for company-sponsored healthcare benefits and retirement contributions are taken into account.

The Second 25%: Housing

Whether you own or rent, limit your monthly payments to no more than 25% of your pretax monthly salary. In other words, figure one week of salary to one month of rent or mortgage payment.

The Third 25%: Debts

It’s also wise to limit your monthly loan payments to no more than one-quarter of your pretax monthly salary as well.

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Speaking as a lender, the closer to 30% your total debt obligations are, the less likely you’ll be able to find a creditor willing to say yes to more.

The Last 25%: Living Expenses

If the first one-fourth of your pretax salary is consumed by taxes, the second pays the rent and the third keeps your lenders at bay, the last 25% will have to take care of everything else, including an emergency savings stash.

Ideally, that should total no fewer than six months’ worth of rent, debt and living costs.

When I do the math this way with my mostly college senior-level students, the reaction is always the same: “Seriously? That’s ridiculous. I can’t live on 25% of my gross salary!”

If that’s the case, it’s time to take a second pass at your plan with an eye towards adjusting the allocations within your control—everything but taxes.

Perhaps the rent will need to be shared or a less expensive space found. Maybe an upcoming purchase will have to wait, particularly if financing is involved.

Then again, if your debt obligations are already approaching the 30% danger zone, you’ll have no choice but to trim the other two categories in order to accommodate that reality.

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The point is that juggling a laundry list of expenses is hard to do without a good sense for how they all fit together, the limits that should be set for each category and the strategic trade-offs you can choose to make.

And if after all your good efforts the money still isn’t making it to the end of the month, consider a suggestion one of my students made a few semesters ago.

Remember what I said about after-the-fact budgeting and dieting?

Well, instead of a writing a diet journal, keep a cash journal for 30 or 60 days in which you record every single expenditure you make in whatever form they may take—cash, check, credit card, debit card, online purchase or ACH—and for whatever reason they were made—food, laundry, gas or lattes.

It’ll help you to find the leaks so you can get back on track.

“The 25% Rule to Budgeting” was provided by Credit.com.