Wouldn’t it be nice if there was a magic ratio everyone could use to know what percentage of his income should go toward living expenses and how much should go toward retirement, a mortgage and debt reduction? While these numbers vary for everyone based on individual goals and needs, there is an accurate way to find your magic number. With just an hour or so of research and calculations, you can determine exactly what you need each month to meet your personal financial goals.
Do Your Homework
Determine what your living expenses are. Last year’s bank and credit card statements will provide most of the information you need. A budget template such as the one found at the website of the Better Business Bureau will help you fill in any potential gaps. List the expected expenses you think you’ll have this year, which will run into the dozens. These include costs such as rent or mortgage, utilities, groceries, phone, car and student loans, insurance, gasoline, auto expenses and taxes. In addition to necessary items, such as rent, include discretionary expenses, such as dining out, entertainment, clothing, gym membership, hair and nails and holiday gift giving.
Create a Budget
Once you know how much you’ll need to spend during the year, put the expenses into a spreadsheet document or personal finance software program. Add a separate entry area for your expected income, including salary, bonus and cash gifts from family. Subtract your expenses from your income to see how you’ll do each month, and how much you’ll have left over for other expenses, such as debt reduction or a vacation fund.
If your expenses are more than your income, or if your excess income seems too tight to help you meet your savings goals, review your expenses to see where you can cut. Start with discretionary expenses first. Cutting out one $30 night at the movies each month and two cups of $5 coffee per week will save your household close to $1,000 annually when you count credit card interest. Being energy smart with your heating and cooling and cutting down on water waste can save another $500. Individually, cost-cutting measures might not seem like much, but they can add up to $5,000 or more annually. If you had started this three years ago, you’d have an extra $15,000 in the bank today. With a little planning, you can still have fun throughout the year without blowing your budget.
Budget Your Extra Income
When you’ve come up with your best guess as to what your excess income will be each month, decide what you want to do with it. Common savings goals include an emergency fund to cover three months’ worth of bills, a home down payment, kids’ college fund, retirement savings or a vacation. You might also use that money to reduce debt. Reducing debt decreases interest payments, increasing your net income and improving your credit score.
Personal finance gurus offer a variety of ratios for personal spending, such as no more than 25 percent of your income for rent or mortgage, and debt-to-available-credit ratios of 20 percent to 30 percent. Mortgage lenders use a guide of no more than 36 percent of your income going toward debt service, which includes your credit cards, student or car loans and mortgage payment. Certified financial planner E. Kim Dingum gets very specific, recommending capping your non-housing livings expenses at 24 percent of your income. U.S. Sen. Elizabeth Warren and former Harvard Bankruptcy professor recommends using 50 percent of your income for necessary expenses, 30 percent for discretionary spending and 20 percent for savings and debt reduction. Once you determine your personal ratio, don’t stick to it hard and fast. As you reduce credit card and loan debt and complete your emergency fund, you’ll have more monthly income to spend or save.
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