In this column, Early Show financial adviser Ray Martin has advice on putting together a plan your family can live with.
Designing a Budget that Works for You
The "B" word and its traditional meaning are likely to make a comeback as tough economic times get tougher this year and next.
The conventional definition of a budget is a financial plan that includes your income and details everything you spend your money on. A balanced budget is a spending plan that does not exceed your income. A wise budget is a spending plan that also includes additional items, such as savings for emergencies, charitable giving, retirement, children's educations, large purchases, etc., and still does not exceed your income.
What should a family think about when designing a spending plan for their family? How you spend your money is entirely a personal matter. For example, what you spend on the "big three" - housing, transportation and food - can vary widely from one family to the next. Do you live in a rural area with two children, or are you single and live in a big city?
If the former, you might need less for housing and more for transportation and groceries. If the latter, then you might spend less on transportation and more on housing and dinners out (single apartment dwellers in New York City tend to use the oven in their kitchen for storage!).
According to academic research on this topic, American spending patterns have changed a lot. Housing expenses have increased the most and now consume about 30 percent of take-home income, transportation takes another 18 percent and almost 15 percent goes to food. Total that up, and 63 percent of take-home income for many families can go to the "big three," leaving the rest for other essential and discretionary living expenses.
Most lenders have typically used a "28-36 guideline" to measure an individual's ability to buy and afford a house. Under that rule, a family's monthly housing expenses, which include principal, interest, taxes and insurance, should not exceed 28 percent of the gross monthly income. Other debts, such as credit cards, car loans and school loans should not exceed 36 percent of the gross monthly income. As this rule goes, if these expenses fall within these "debt-to-income-ratio" guidelines, then, typically, an individual is in good financial shape as far as their income and debt payments are concerned.
But this rule is incomplete and can result in severe budget and financial difficulty if acted upon under certain conditions. For example, since this rule is based on gross income, it can translate into spending about 35 percent of take-home pay on housing and over 45 percent on housing and all other debts. Also, it does not specify what the other debt payments should be.
For example, if an individual is making interest-only payments on their mortgage and credit cards, then their debt payments might fall under the 28/36 rule, but when factoring in a reasonable interest rate and principal payments to pay down debt, they could be way over these limits and, as a result, cannot reasonably afford their debts.
Hmmm … maybe banks will now reconsider this "rule"?
But what should you spend and how should you set up a budget? That is a personal matter as well, but budgeting experts offer these suggestions:
Budget envelopes: Some folks deposit their pay into an account and leave in there the amount required to pay for regular monthly expenses, such as rent, mortgage, car payment, utilities, etc. They move the remainder into another account for all other spending categories, such as dinners out, shopping, movies, etc. An old-school trick some folks have used is to withdraw this remaining money and separate that cash into envelopes with labels for each discretionary category. When you want to go to a movie, look into the movie envelope to see what you can then spend. If you've already spent your "movie money" this month, then you can either forgo the movie until next month or use some money in another envelope and cut back on that other category.
Reverse budgeting: Other folks practice what is called "reverse budgeting" - they pay all their essential bills immediately each month and use what is left to cover any discretionary spending.
Here is another budget tip: when big companies fall into financial difficulty, they gather detailed reports on expenses, sort these from biggest-to-smallest, then work on expenses, starting with the biggest ones at the top, then move down the list. Individuals who are serious about saving should do the same. That's not to say saving on the little things isn't worth the trouble - I truly believe in the adage, "Save the pennies and the dollars will follow," but first, focus on bigger savings opportunities, such as refinancing to lower cost debt, selling a second, unnecessary car, opting to take a local vacation as opposed to traveling, etc. Then, move on to other budget saving moves, such as raising your deductibles on home and auto insurance, taking defensive driving course to get a safe driver discount, car-pooling, cutting back on prepared food, etc.
The point is that your spending plan should be one that works for you - just get on a plan that makes you conscious of what you spend and helps you identify ways to control it.
Another budgeting technique is to keep a detailed record of all of your expenses, separated into spending categories. When doing this, you might find you spend over $400 a month on dining out, or over $15 a month on ATM fees.
But keeping a list of your daily expenses can be a tedious affair, and so you might consider budgeting tools and services that are available to offer some help. A popular personal finance tool is Quicken, which has a longstanding following (including yours truly). This personal financial software has an interface that looks like a checkbook register in which the user makes an entry for each expense and assigns it to a spending category. When this is done, the user can run monthly expense reports that will show all expenses in each category, including charts, graphs, and how you compare to prior months. Users can also set up the software to download information from their other financial accounts, such as credit or debit cards and investment accounts. The downside is the time required to set this up and maintain it, an issue that's often cited by those who have tried and failed.
A recent NYT column introduced another simpler solution called Mint (www.mint.com). According to Aaron Patzer, the founder of Mint, a Web site that collects your spending data from enrolled bank and credit card accounts, "Most people don't know what they spend in every single area, but they know they have a problem in particular areas." Using Mint, folks can create an "account" and link their credit and bank accounts to it. Then, Mint's money management software takes over and automatically downloads the transaction information (dollar amounts and places where spent) into the Web site's account for you. Users may have to assign some items to categories, but others, such as purchases at Target, should fall right into the shopping category. When this works, you'll know what you spent on everything from groceries to gas last month and have access to reports and graphs to view online.
Then there is the fun part: Mint allows you compare what you spend in a category to what others in your peer group spend, which may or may not be relevant, but can be addicting and help you identify what areas of your spending you may need to better control. Other services that can offer similar services are the online version of Quicken and Wesabe.
What to do if you are having serious budgeting problems?
Finally, if you need outside help, discuss your family's financial situation with a credit counselor who is a member of the National Foundation for Credit Counseling, or an attorney who specializes in bankruptcy.