Rules of Thumb

Rules of Thumb

I learned budgeting in my college days.  My dad required me to do a 6 month cash flow projection before I got my ‘student loan’.  I am sure I was the only student who had to do that.  After 20 plus years of working with people and their money, I think every college student should be required to create and live by their cash flow projections.

My years as a financial advisor, I have learned a few things that makes creating and keeping a budget easier.  I have found the biggest stumbling block in keeping a budget is the non-monthly expenses.  Things like Christmas and gifts, vacations, medical expenses, car repairs, clothing and home maintenance.  When you pay a monthly bill it is easier to keep on track with your spending plan.

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So the key is to make a monthly bill for every item in your spending plan.  You set the money you have allocated for a vacation, car repair and other non-monthly expenses into a savings account.  I refer to this as a buffer account.  If you leave the money in your checking account you are likely to spend it on other things, and be short when you need it.

When you need to pay for a car repair, you transfer the monies from your buffer account into your checking account to pay the bill.  The same applies for all the non-monthly expenses.  You can keep track of your non-monthly expenses – accruing the monthly allocation and subtracting your expenditures, and keeping a balance in each expense category.

However, if you aren’t one for details, or you don’t have the time, you may want a simpler approach that you can maintain.  Success in a spending plan requires your being consistent.  An easier approach is to total the monthly allocation of your non-monthly expenses and transfer it into your buffer savings account.  Pay all your non-monthly expenses from the buffer account.

This approach allows you to have ‘fun’ on your spending plan and not feel guilty or get caught short some months in meeting your bills.

I frequently am asked how much should be allocated on different budget items.  I see so many variances in people and their likes and dislikes.  Some people have 3 closets of clothes, others take extravagant vacations and some have great collections of art or coins or books.  I think you need to make room for your own personality or you won’t keep a budget/spending plan.

There is a general rule of thumb to follow.  Put 10% of gross income away for long term goals like retirement and college.  Put 20% away for debt reduction and cash reserves.  And use 70% for monthly living expenses including the mortgage.

An easy way to accomplish the long term goal portion of your spending plan is to have automatic deposits into savings or retirement accounts.  Company retirement accounts like a 401(k) have payroll deductions.  You may be able to have payroll deductions made into a savings account or you can do an automatic banking transfer.  Making the monthly contributions automatic is helpful in obtaining your financial goals.  It is the easiest form of budgeting.

20% of your income going to debt reduction and cash reserves is also a critical step.  A cash reserve is different from your buffer accounts.   While it is still a savings account, you use it in time of an emergency.   An emergency is defined as something unforeseen and unexpected; something such as losing your job or being off work due to an illness.  A sale at the department store does not qualify as an emergency.

Your cash reserve should be 6 months of your bare bones budget.  I encourage you to keep the first $5,000 liquid in a savings account.  The balance can be in CDs – probably longer terms to get a better interest rate.

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Another rule of thumb is to keep your housing costs within 25% of your monthly income.   A house is one of the biggest investments a person will make.  You want to be able to do the necessary repairs to keep it functional and attractive.  But you don’t want the house to become a ball and chain if you can’t easily pay the related bills.   And you really don’t want to experience a foreclosure.  While many are walking away from their homes, I wonder how many could have kept their home if they had stayed within 25% of their income.

One obstacle to staying true to a budget is keeping harmony in the home.  Spouses can have different ideas of what is important to spend money on.  Finances are one of the leading causes of divorce.    One option to keeping harmony in the home is setting up accounts for each spouse that I call “Mad Money”.  This is an allocation of a reasonable amount of money for each spouse.  (Reasonable is defined by what your spending plan allows.)

Mad Money is having money to spend you don’t have to account for.  So if you have a hobby you want to indulge or you really like shopping for clothes, you can do that without ruining the budget and hopefully keep harmony in the home.

Follow these rules of thumbs and you will move towards your financial goals.

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