A couple years ago, an extremely influential article entitled popped up on MSN Money. It proposed a very simple way to budget:
After analyzing our spending patterns over the past couple of years using our Microsoft Money data file, I determined that we needed to keep our committed expenses at or below 60% of our gross income to come out ahead at the end of the month.
* Basic food and clothing needs.
* Essential household expenses.
* Insurance premiums.
* Charitable contributions.
* All of our bills — even such non-essentials as our satellite TV service.
* ALL of our taxes.
I’m not saying that 60% is a magic number. It’s a workable goal for my family, and it’s a nice round number. But your number might well be a bit higher or lower. At any rate, it’s a good place to start.
Then I divided up the remaining 40% into four chunks of 10% each, listed here in order of priority:
Retirement savings: consisting entirely of my 401(k) contribution, which is subtracted automatically from my paycheck.
Long-term savings: also automatically deducted from my pay to buy Microsoft stock at a discount as part of an unusual stock-purchase program. The relative lack of liquidity (i.e. the difficulty of turning these shares into cash) makes it harder to spend this money without some planning and a series of deliberate steps. In a real emergency, though, I could sell and have the cash wired into my bank account within three days, so this is also our emergency fund.
Short-term savings for irregular expenses: which are direct-deposited from my paycheck into a credit union savings account. Money in this account can be easily transferred into our checking account, as needed, via the Web. Over the course of a year, I expect to use all of this money to pay for vacations, repairs, new appliances, holiday gifts and other irregular but more or less predictable expenses.
Fun money: which we can spend on anything we like during the month, so long as the total doesn’t exceed 10% of my income.
So, they spend 60% of their income each month on required expenses (food, house, taxes, etc.), sock 10% away into a 401(k), sock another 20% away into long term and short term savings, and spend the other 10% on fun stuff. This general framework became so popular that it has been incorporated into recent versions of Microsoft Money, making it easy for people to organize their finances using this model.
I basically feel that this is a fantastic framework for people who are trying to get their money straight but have no idea where to start. A few little caveats, though:
60% is a baseline, not a hard and fast rule. If you dive in, I suggest starting with 60% and seeing how it goes. If you actually find it easy, try some frugal things and see if you can turn it into the 50% solution (and kick that extra 10% into savings); if it’s extremely difficult, make it a 65% solution for a while.
Frugality helps. Being frugal cuts down on that 60%, making it easier for you to reach that target or, even better, enable you to beat it. Doing things like installing CFLs instead of incandescent bulbs and practicing good shopping habits simply shave money off of what you owe every single month, resulting in some serious breathing room.
The short term savings is basically an emergency fund. As I’ve mentioned before, an emergency fund is one of the best assets you can have because it can earn at a solid rate, protect you from going into debt when the inevitable happens. If you don’t have one and are thinking of diving into the 60% solution, I would redirect some of the long term savings into short term savings until you reach a pretty solid number for your emergency fund. Personally, I’m shooting for eighteen months’ worth of emergency fund as soon as I can manage it – a very large emergency fund is personally important to me.
Don’t beat yourself up if you try it and at first don’t succeed. This is true for any personal finance goal, because such goals are a lot like diets: people set very difficult goals right off the bat, fail to reach them, and thus use that as an excuse to fall back on bad habits.