By Richard Serlin
Adjunct Professor of Personal Finance, the University of Arizona
The foundation of budgeting, and in fact of personal finance in general, is the Balanced Money Plan of Harvard Professor Elizabeth Warren. This plan says to:
- Spend no more than 50% of your after-tax income on fixed expenses, which are anything you have to pay for each month, and cannot cut back in the short run. This includes your rent or mortgage, any car payments, basic food, basic utilities, insurance, etc. Professor Warren calls these things "Must-Haves".
- Save at least 20% of your after-tax income every month.
- And the rest of the money can be spent on anything you'd like. This is your discretionary spending, for example eating out, a new dress, a big screen TV, anything you'd like. Professor Warren calls this spending "Wants".
If saving 20% every month seems very hard, or impossible, to you, this is probably because you are spending much too much on Must-Haves. The most important single piece of advice in personal finance is to cut your Must-Haves to under 50% of your after-tax income. If this means selling your new SUV and Honda Accord, and buying two 10 year old Honda Civic EX 4-Doors, then that's what you must do. It will be well worth it to stop constant financial stress (and possibly ruin), and constantly denying yourself the little day-to-day pleasures, to pay hundreds of extra dollars each month to your cars.
If it means selling a home you can't truly afford, then you just have to do it, and move to a smaller one, or a less fancy neighborhood, until you save enough that you can really afford it without constant financial stress, deprivation, and danger of ruin. Your Must-Haves must be brought under 50% of your after-tax pay. The little things like clipping coupons, bringing a bag lunch, etc. are good, but they are just dwarfed by the big fixed expenses – These have got to be dealt with, and eventually cut to less than 50% of your after-tax pay.
With Must-Haves under 50%, if a crisis hits, like losing your job, you have over 50% of your spending (and saving) that can still be cut back immediately, as only Must-Haves are not immediately cut-able. This means that you may be able to weather the storm just on the income of a spouse, or unemployment compensation, without destroying your savings, and after that falling into a ruinous debt spiral.
An important note on Must-Haves is that although they should essentially never exceed 50% of your after tax income, the riskier your income, and life in general, the lower they should be. For example, if you are self employed, and there is a substantial risk of business going bad and your income dropping in half, your Must-Haves should be much lower than 50% so that if this does happen you can weather it without destroying your savings, and then descending into a spiral of debt leading to ruin.
If you have children and a mortgage, you are unfortunately usually more at risk financially; if things go wrong, you are not some 25 year old who can easily ask his landlord to find a new tenant, and then bunk with a friend, or move back in with Mom and Dad.
And the older you get, typically, the more specialized and high income your job gets. Unfortunately, this usually makes it much more likely that if you lose your job, you won't be able to find another one paying nearly as much. As a result, for most people it makes sense to lower your Must-Haves by about 5% relative to your income every 10 years, at least until your Must-Have percentage is in the 30's.
A great way to do this is, when it does make sense to buy a home, you obtain a fixed payment mortgage. That way, as your income goes up, your mortgage stays the same, lowering your Must-Have percentage. It is also always a great idea for financial security to pay off your mortgage as quickly as possible.
For more details on the Balanced Money Plan and its implementation, please read the first 40 pages of our free personal finance course (and hopefully finish the course).
The Balanced Money Plan was first designed by Harvard bankruptcy and personal finance expert Elizabeth Warren, who among her many achievements was selected during the economic crisis of 2008 to chair the Congressional Oversight Panel for Economic Stabilization. Her inexpensive book, "All Your Worth: The Ultimate Lifetime Money Plan", I believe, is by far the best personal finance book available today. I strongly recommend anyone read it.