Rules of Thumb

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.

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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