Your personal budget may seem like little more than a set of restrictions or limitations. It is extremely short sighted to think this way. Your personal budget sets your financial path. Acting without this budget will result in large amounts of financial waste, and decrease your ability to properly pay down debts, save, or invest.
Personal Budgets will alert you what you can spend and when to spend. If your budget exceeds your means, your financial life will be nervous and difficult. Your budget begins with how much money you’re earning, both monthly and annually. Certain expenses occur monthly, but many of your expenses occur every quarterly, biannually, or once a year. The same may occur with your salary, wages, residuals, and earnings. Add all of your sources of income. Some of this money should be automatically sent to investment or savings accounts. Do not include money placed in any retirement accounts, and consider this money to be off limits. You won’t use income routed to a Normal or Roth 401k, 403b, 457, IRA, SEP IRA, or Roth IRA. That money is for your long term future, not spending. Record your income per month for each month of the year, then tally the total annual income.
Record and Categorize Expenses
After calculating your income, record your expenses. Work backwards for as many months as possible. All of your expenses will fall into two categories. Expenditures you have to pay and those you have a choice of paying. Your compulsory expenses are typically services provided by others and billed monthly, bi-annually, or annually. They also include food and drink. They are needed for survival.
Your other expenses are discretionary, and not required. Some examples are clothing, coffee, jewelry, luxury items, music, and books. These are choices you make because you want to, but not because they are essential. This can surprisingly range from thousands to tens of thousands of dollars per year. Add up your averages from a weekly or monthly basis.
Add both your compulsory and discretionary expenses. This shows you where exactly your income is spent each month. Some of this will be surprising to you, and it should be. That’s the goal. You need to reduce your discretionary expenditures while adjusting your compulsory expenses. When completed, budgets help maintain a comfortable lifestyle while resulting in substantially more money for savings, investment, and eventually wealth.
Divide Your Expenses
Your budgeted income divides fairly simply. Up to 60% of your income will go to your compulsory expenses. This means housing, transportation, utilities, food, and health insurance. Yes, health insurance is a required expense if it is not provided by your employer. Medical accidents are too expensive for you to ignore purchasing health insurance.
20% of your income should go to paying debts, building your emergency fund, increasing your savings, and building your investment portfolio. If in debt you should save 5% of your income each month and send 15% to paying debts. You should always pay yourself first. Tend to your net worth with the highest priority each paycheck.
Paying yourself first occurs in the following order:
- Save $1000 in your savings account. This operates as your small emergency fund.
- Pay your debts, from the largest interest rate to the smallest interest rate. (Note: Mortgage is not included. Your mortgage will be paid in the housing budget section. This is for consumer debts, like credit cards, or student loans)
- Expand your savings account to 3 months of expenses.
- Max out your tax advantaged retirement accounts annually.
- Invest in your ordinary brokerage accounts.
If you’re having trouble paying debts, work out payment plans with organizations whom you owe money. They will often agree that being paid a little is better than being paid nothing at all. As you eliminate your debts you can direct more money towards your savings and investments.
Your housing budget should be under 35% of your income. Cheaper is better since it is hard to downsize your housing after you already moved in a new residence. Under smaller incomes, the best way to go is getting a roommate.
Your transportation costs, including vehicle insurance, should receive up to 15% of your budget. Note that this works out easier if you save to buy a used car you can afford in cash for as little as possible.
Utilities should receive up to 10% of your total budget. You may be forced to eliminate certain services to meet your budget (such as cable or satellite TV). Electricity, Water, and Phone are the absolute essentials on this list.
Your food budget should be around 5% of your budget. If you’re having trouble meeting your food budget, eliminate restaurants or fast food chains and plan your purchases before grocery shopping.
Health Insurance should be another 5% of your budget. You cannot afford to be without health insurance. The world is filled with people who did not have health insurance, and in an emergency wound up with tens of thousands of dollars of debt.
The remaining income is directed to your personal desires, luxuries, social interaction, and entertainment. This is true only if you can afford it. This section of your budget is sacrificed first to pay for your other compulsory expenses. If your other expenses tighten, this section is easiest to eliminate in to meet your personal needs. If you are in debt, this section should go towards paying your debts. If you have no debts and prioritize building your net worth, direct 10% or more of this section to savings and investments.
You should still have freedom to enjoy yourself, so don’t punish yourself by directing all your entertainment budget to investment or savings.
It should be noted that in many cases, people allocate entirely too much money towards compulsory spending. Their monthly expenses add up to large percentages of their annual budget. When purchasing any monthly payment service, including rent or mortgage, add up the annual cost first.
Always multiply other monthly, quarterly, or biannual costs to reveal their annual costs. Add the annual expenses together for each category: Housing, Transportation, Utility and other costs. Then divide your annual salary by the total annual expense from each category to receive it’s percentage of your current budget. If the percentage is too high, pass on the purchase and find a cheaper alternative instead.
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