Having a handle on your budget is a building block for other good financial practices. If you can grasp the concept that sacrificing a few items today will allow you to buy more items later, you’ll have a better chance at affording the important things: houses, cars, vacations, educations, etc. I had a difficult time conveying this concept to my brother, who believes that money is better enjoyed as a young wonderer in the world and becomes an item of necessity rather than pleasure as one gets older. I think he’s referring to life events such as marriage, children, housing, and education which are expensive and typically require a large percentage of your after-tax funds. I agree with him in one respect: that money has more of a shock affect when spent on items that pass quickly, such as vacations and meals. However, he (and many others) may be overlooking a crucial link: responsible spending on the not-so-fun things such as mortgages and retirement savings is directly related to one’s ability to spend more later on in life. Believe it or not, there are objective realities (the classic examples being death and taxes) which we need to plan around. If we are to lead fruitful lives, understanding the impact of spending will be very helpful down the road. Below I will discuss some budgeting basics that I consider to be important and integrate the financial journey of my hypothetical friend, Jay. He will be a single male from Chicago who is having some trouble with his budget. I’ll also point out some websites and blogs which give fascinating if not overly detailed discourse on the budgeting tactics that people use.
The three areas of life which tend to cost the most are housing, transportation, and food*. Think about how much time you spend either in your home, getting from place to place, or eating. It’s a very funny thing to think about as it puts into perspective just how similar the activities of most human beings are. In fact, the percentage of money spent on these three items is nearly identical for both low-income and wealthy families; the difference being the size of the home, the newness of the cars, and the variety of meals. As a rule of thumb, spending approximately one third of net income on housing is a responsible figure. This means if you earn $40,000 but your take-home pay (after taxes) is $30,000, you should be spending approximately $850/month on either your rent or mortgage payment. Keep in mind that each person’s situation is different, and many factors could alter this percentage higher or lower. The next third of your after-tax pay should cover food and transportation. While I tend to think this percentage could be lower, food is both a shockingly popular and expensive industry throughout the world. I suppose it makes economic sense because people love to eat and have no qualms about paying for food. Transportation has a similar story: a majority of people could drive economy cars which utilize alternative energy sources, but choose not to. We drive sport-utility vehicles that cost $50 or more to fill up at the gas tank. The economic explanation for this is that we don’t feel the pressing need or collective desire yet to radically alter the way we transport ourselves. While these subjects warrant discussions of their own, the point is that much of what could be comfort money is spent to cover the sky-high costs of eating and getting around.
Let’s move on to Jay, our financial planning example. Jay’s a real city personality; a computer programmer, single, active lifestyle, all that stuff. I chose him as an example since his after-tax, disposable income is around $2,500/month, fairly close to the median statistics in the United States. I believe his situation typifies in many ways the sort of budgeting mistakes which people tend to make. The rent on Jay’s studio apartment is $1,000 per month. While this is above the $850/month I would have recommended, he partially compensates for it by not keeping a car in the city. Jay’s apartment, including his cable and energy bills costs $1,200/month. He spends a total of $14,400 each year, or 48% of his disposable income on the apartment. Jay could easily lower that number to $1,000 by either getting a roommate or taking a place a bit further from the center of town. Besides the fact that Jay likes where he lives, he insists on keeping the apartment because transportation costs would become too high if he moved further away from his job. Food is an important expense for Jay as well; he eats only organic and tends to shop at stores like Whole Foods and Wild Oats. However, he doesn’t eat out at restaurants very often which offsets the expense of locating organic foods. He estimates $4,800/year or 16% of disposable income on food. Transportation is the third largest expense at 8% of his disposable income, or another $2,400/year. It would seem that most of the big ticket items are out of the way at this point. However, Jay not only spends his disposable income each year, but he saves nothing and is starting to develop credit card balances (It’s not actually a syndrome). His other hobbies include taking an annual trip to Florida with friends, buying music online and playing poker. Jay says there are probably a lot of expenses he is forgetting such as birthday gifts, haircuts, gym membership, etc, which push him over his spending limits. Our estimate is that of the $30,000 in disposable income, Jay spends $31,000/year and saves nothing. Saving, he insists, is something he’ll start thinking about in his 30’s.
The first thing I like to teach “non-savers” is that they can save. The secret, which I’m happy to share with everybody, is to treat saving like a monthly bill. If you get paid on the first of the month, have $100 taken out of your account on the 3rd of the month and directed into an interest-bearing account. If you have a retirement plan at work, it should be utilized first as there are often tax benefits to participating in these plans. You should start this habit of automatic saving as early as possible and never stop. Granted, you may start earning larger sums of money in which case $1,000/month is better suited for you. Regardless of the amount, saving money should be as high a priority as any bill is. If it’s not, cut your HBO and start with that extra $10/month. Next, ditch high-priced coffee and start making it at home. That piece of advice alone could save you $100,000. Does that figure sound crazy? Take a look at the chart below which examines the opportunity cost of spending $3.00 a day. If coffee is a bad example for you, substitute it with some other habit you could cut back on: cigarettes, buying lunch, dry cleaning etc.
Y Cost/Cup Cost/3% Infltn Total Paid Invested Instead at 7%
1 $3.00 $1,095.00 $1,095.00 $1,172.00
2 $3.09 $1,127.85 $2,226.00 $2,267.00
3 $3.28 $1,197.20 $3,384.00 $3,520.00
5 $3.48 $1,270.20 $5,814.00 $6,297.00
10 $4.03 $1,470.95 $12,553.00 $15,129.00
20 $5.42 $1,978.30 $29,423.00 $44,890.00
30 $7.28 $2,657.20 $52,095.00 $103,434.00
This chart could be used to illustrate other financial planning concepts, such as the time value of money, and the effects of compounding. For now, we’re only concerned with opportunity cost; what we forego when we spend
$3.00 instead of putting it into the bank. Anyway, these are changes which could be beneficial to Jay:
•$100 automatically deducted each month and directed into an interest bearing account.
•Capping food store runs at $50/week ($16 less than his current average). This would save approximately $862 per year which could be invested. We made this decision upon a further discussion where Jay revealed that he tends to overspend slightly and could buy just as much food even at $50/week.
•Starting to use a debit card or cash rather than a credit card for expenses. Studies show that people who spend mostly cash tend to be more frugal, while active credit card users tend to overspend. Jay was a classic credit user who paid back less than his full balance at the end of the month. This practice gradually leads to higher credit card balances.
•Jay is starting to investigate his situation at work. He will begin contributing the minimum to the company 401k plan next year. He will also discuss with his employer opportunities to increase his pay next year.
Keep in mind that budgets aren’t just for the struggling. Many smart and rich people have less than perfect financial habits too. Did you ever hear that both Mike Tyson and Michael Jackson had severe financial problems? That just doesn’t sound right. If somebody gave me three million dollars to punch people out I promise I’d save at least half. The tendency for people with larger incomes to fail at budgeting is a more complex issue as is the process of keeping to a budget when you don’t receive a regular salary. A classic example of this would be sales or commission-based jobs such as brokers. Some of these people may earn $20,000 one month, take three months off, and then earn $20,000 again. It can be very tricky to make a longer term spending plan with this type of erratic earnings schedule. However, the steps are the same: write down your expenses, analyze what you could be cutting back on, and be sure to save a little something each month.
On the web, there are a lot of bloggers who publicly track their spending. One such blog is Consumerism Commentary. The master of this site, Flexo, posts a balance sheet each month illustrating changes in his net worth for his readers. He breaks down his assets into cash accounts, investment accounts, and intangibles such as accounts receivable and automobiles. The blog also features articles on various topics that tie into personal finance such as shopping and selling things on Ebay. Flexo is also a contributor to the Money Blog Network which conveniently compiles the entries of top personal finance bloggers onto one site. One such blogger on this network, “FMF” writes Free Money Finance. This is another well-written and comprehensive blog loaded with tips on saving money, sorting through financial documents, navigating retirement, and a host of other topics. Finally, I have a great website for those truly focused on their budgets. Visit www.stretcher.com to really find out how to squeeze every last penny out of your dollar. This incredible resource will help you save money in ways you haven’t even thought of. Visit the topic library at the bottom of the home page for the long list of articles.
Premier Financial Advisors
14 E. 60th St. #402
New York, NY 10022
*U.S. Department of Labor, Bureau of Labor Statistics’ Consumer Expenditure Survey 2004
Securities and certain investment advisory services offered through: FIrst Allied Securities, Inc., a registered Broker/Dealer. Member: NASD & SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.