For most people, balancing personal budgets is a tedious and time-consuming process. These days, though, the task has become even more challenging.
According to the Federal Reserve, average household debt in the U.S. increased 5.25% during the quarter ending Sept. 30, which isn’t surprising given that annualized real (net of inflation) wage growth continues to be negligible: less than 1%, according to the Department of Labor.
Household budgeting is a zero sum game: there are only so many dollars to go around before savings accounts are drained and credit becomes scarce.
Too often, though, this fundamental tenet of good personal financial management is undertaken in hindsight—long after spending patterns become legacy, rents are locked-in and the debts are racked up. At that point, budgets feel more like diets than they do menus.
Fortunately, there’s a better way to approach this task.
Start by dividing your before-tax income into four equal parts and grouping the daunting list of expenses your paycheck needs to cover into four categories: taxes, housing (rent and/or mortgage), debts (excluding mortgage payments) and living expenses.
The First 25%: Taxes
Face it, the money you earn is going to be taxed. Between the various federal and local assessments (including Social Security and Medicare), figure on a bill that could total 25% of pretax income for moderate earners, particularly when payroll deductions for company-sponsored healthcare benefits and retirement contributions are taken into account.
The Second 25%: Housing
Whether you own or rent, limit your monthly payments to no more than 25% of your pretax monthly salary. In other words, figure one week of salary to one month of rent or mortgage payment.
The Third 25%: Debts
It’s also wise to limit your monthly loan payments to no more than one-quarter of your pretax monthly salary as well. Speaking as a lender, the closer to 30% your total debt obligations are, the less likely you’ll be able to find a creditor willing to say yes to more.