The simple formula for creating a budget is this: take your gross monthly income and subtract your taxes. The result is your disposable net monthly income (DMI). Allocate 50% of that money to your Bare Necessities, 30% to your Wants and 20% to your Savings. This is the basic plan for long term budgeting of all your finances. Everything else can be placed into one of these categories.
I have discussed the Bare Necessities and Wants elements in prior blogs. Now let’s look at the Savings category in more detail. The concept is to take this 20% and over time deal with it in 4 stages. The first stage is to place and always keep an extra $1,000 in your checking account–not what you are paying your bills with. This is a buffer fund for breathing room. It allows you to pay your bills in a timely fashion without fears of bounced checks, uncleared deposits you’ve made, or meeting those relatively small, unexpected bills that crop up. This is a perpetual cushion, so every time it goes down, you need to apply your monthly Savings to bring it back up. And remember it should not be part of your plan to constantly consume this fund!
Let’s say you have $3,000 per month in DMI. Twenty percent of that amount is $600 for your Savings. First you build up the $1,000 cushion. Next, whenever you used part of the $1,000 that month, then you need to replace it. So if it were $100, this leaves $500 in Savings for that month. The second stage is to use your “Savings” to pay down your debt. This debt is not your Bare Necessities debt, like your mortgage, car payment or student loans, but the rest of the money you owe. The typical categories for most people are unsecured credit card debt, personal loans, and most other kinds of debt on which you have some required payment each month. The interest rates and fees for these debts are usually way too high and they are always limiting your financial freedom. For example, the average family has $8,000 in credit card debt. At a 22% interest rate, over $1,600 a year is being shelled out in interest alone. That is throwing your hard earned money away (while the CEOs of these companies “earn” tens of millions of dollars in salaries each year!)
It will take time to apply your Savings to pay off these debts. But it is very import ant to get them out of your life–one at a time. Work hard to whittle them down until $0 is owed. You will be lifting an enormous weight off you back. And as I emphasized before, the other side of this coin is DO NOT TAKE ON ANY MORE DEBT. Cut up and throw away the credit cards and short of an emergency, just do not borrow money. Live on a cash basis and adjust your Wants to fit within your budget. Taking out credit has been easy in America because of the way the law has evolved to help creditors. Credit has been so liberal that until recently when the credit bubble burst it was treated as “Savings” itself (such as the untapped available funds on your credit cards). The mentality was “just buy and if you run out of money, borrow some more.” This had become a habit for people–a very bad financial habit. So steel yourself and stop it, despite the luring ads and promos from the “pushers” in the credit industry trying to seduce you into their trap.
Once stage 2 is accomplished, which will certainly take time and patience, you then can step onto stage 3–a Savings security fund. This is an emergency fund to offset an unexpected major expense (like your furnace dies) or your income is reduced or even stops. Maybe you get sick, are in an accident or are laid off. There are black holes that sometimes pull us in (we hope temporarily). The way to meet these is to have created a fund that covers your Bare Necessities for 6 months. In our example of $3,000 DMI, your Bare Necessities would be $1,500 (50%). You would need to have an ordinary savings account which is easily and readily accessible of $9,000. This would get you by for 6 months if the income dried up. You can pay your food, work related travel, rent/mortgage, etc. in your Bare Necessities. Stage 3 requires that you take the 20% and put it aside to build this fund. At $600 per month it will take 15 months to reach the goal. But this will give you a very great backstop in case of big emergency.
The fourth stage of Savings is money for the future. I will have a separate blog on this next time.
Enjoy.
*Post theory is primarily derived from the book All Your Worth by Elizabeth Warren & Amelia Tyagi which is highly recommended reading.
Iowa Bankruptcy Attorney Robert Liptak
Fairfield, Southeast Iowa