Home-Economics Series 1 – Budget Rules of ThumbPosted: February 28, 2014
Making a budget is simple. In fact, the simpler the better. Here’s how I do it.
If you’re a regular reader, you already know how I break down expenses into fixed recurring expenses and flexible ones. Fixed expenses include:
- Housing. The cost of this depends a lot on your area, but we’ve never spent more than 30% of net pay, and I certainly wouldn’t feel comfortable exceeding that. A few good rules for housing include: being within easy biking distance (<10 miles) of work, shopping, and any other regular destinations, having a place to garden, and ideally less than 200 sqft per person.
- Communication. This includes internet and phone service. Less than $100/month is reasonable.
- Debt. Obviously, try not to have any debt at all, but if you do have it, know exactly what you pay and what your interest rates are. Put as much free cashflow as you can each month towards the highest interest rate debt, unless all of your debt is below 4%. Between 4-5%, the “return” from pre-paying debt and real rates of return (capital gains minus inflation) from market investment will be on par with each other.
- Health. This includes insurance and any regular prescriptions. With the rapid fluctuation in price year to year, it’s hard to offer any rule of thumb in raw dollars, but a general rule is to use a HDHP combined with an HSA whenever possible. Investing in an HSA is the single most tax-efficient vehicle offered in the US, since it avoids income and FICA taxes, and after 59.5 years can be used for general spending, not just health expenses. The exception to this rule is if you have a chronic condition where constant and regular expenditures are cheaper under a more full-coverage plan.
- Property/Auto/Life Insurance. The primary rule of thumb here is to consider how much insurance you truly need. Wherever possible, act as your own insurance company. See this excellent post over at RootofGood for more details.
- Utilities (water/sewer/electric/gas/trash). These will vary widely based on your area, size of residence, etc but optimize as much as possible. If you own a house, many homeowners consider the several hundred dollar cost of a professional energy audit the best money they’ve ever spent.
Where people typically trip up is in tracking flexible or consumable expenses. I use the lowest-tech method to track expenses: pen and paper. Each month I grab a blank sheet of paper (or blank side of a piece of scrap paper) and grid off 5 separate categories:
- Necessities: this is all essential spending, including groceries and household items (toilet paper, cleaners, light bulbs, etc). Food costs vary by area, but a generous rule of thumb is $150 per person, per month including alcohol.
- Vehicle Fuel and Maintenance: this varies based on your commute length, but drive as little as possible. If you are single or have no kids, consider not owning a car at all. I am consistently floored by how much the average American devotes to transportation. This should not be your #2 area of expenses. For us, cars are behind housing, medical, and necessities.
- Medical Out of Pocket. Useful especially if you need to make transfers from an HSA. Personal health varies widely, but if you have regular, recurring expenses consider any and all lifestyle changes you can do to reduce or remove prescriptions and other costs from your life.
- Discretionary. This would be any joint purchases (if you’re a couple), including furniture, appliances, and also agreed-upon spending of shared ‘couples’ money if you’re in a relationship. Any spending here should be carefully evaluated against your savings goals, whether something is available used or free through Craigslist, etc.
- Personal. A guide to marital peace is having a monthly “mad money” account where each partner can spend, no questions asked. Consider this recommended but optional.
Now comes the reckoning. Based on your net income, how much money is left over each month? Ideally, you should be saving at least 50% of your net income. This will allow you to retire in 17 years. Considering the gains in productivity since the 19th century, you’re wasting money if you can’t hit this meager goal.* If you can’t possibly see how you could do this, comment here, but I would strongly consider posting a Case Study at the MMM forums where there are a lot of other smart people besides yours truly willing to help. If you’re on an income close to poverty level or below, read the book Early Retirement Extreme.
More than anything, open your mind. Be flexible. Money purchases time. Time is freedom.
The higher the percentage, the shorter your work life becomes. The math behind this is shockingly simple. The Goblin family is behind the eight-ball thanks to student loan debt and an underwater house not eligible for HARP, but we live on a very small percentage of our income. It will take us longer to become debt free than it will to amass enough assets to be financially independent.
*If you’re offended by the word “meager” here, you need to evaluate just how thoroughly your life is dominated by advertising and a misalinged scale of needs versus wants.