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Lesson 2a: Budget (continued)

Objective: Review your budget to see if you can handle any unexpected changes.

Everybody's budget will look different. In reviewing your budget, there are three items to pay attention to:

How comfortable are you with the choices that you are making (e.g., spending more on eating out compared to spending for a vacation)? Do you have any regrets or worries?

Determine how much risk do you have with large fixed payments that can not be changed easily like mortgage or car payments? Will you be able to meet expenses if something happens, like losing your job or your spouse deciding to stay at home to raise your children?

It is important when you have changes to your budget (e.g., purchase a new house), that you make sure you are comfortable with the risk that you are taking on with the new large fixed payment. Most people ignore this until it is too late and then realize that they are in over their heads.

Do you have room in your budget for surprises (e.g., increasing gas prices)?

Many financial advisors suggest a few rules of thumbs when you review your budget.

Total housing payment (loan payment, taxes and insurance) or rental expense should be less than 28% of owner's gross pre-tax income.

Total debt payments should be less than 40% of gross income.

Savings should be at least 5 to 10% (and should be more).

If the house or debt payment is greater than the rules of thumb above (the upper limits that one should spend), then there is little flexibility in the budget.

Elizabeth Warren and Amelia Warren Tyagi, in their book All Your Worth, suggest dividing your budget into three pieces ("Must Haves", "Wants" and "Savings") and

Keeping "Must Haves" below 50% of post-tax spending (fixed expenses such as house payments, utilities, food, etc.)

Keeping "Savings" at least at 20% (including accelerated mortgage or loan payments that are above required minimum payments)

Keeping "Wants" at remaining 30% (everything else)

These principles focuses controlling the risk of what happens if there is an unexpected change in income due to losing a job, becoming disabled or one spouse deciding to stay at home to raise the family. The question to their readers is can you make enough spending cuts to accommodate the new situation? The 50% "Must Have" limit is based on if one person in a two-income family loses their job, there is enough room to cut "Saving" and "Want" budget items and survive through unexpected changes. If "Must Have" (the fixed payments) are greater than 50%, there is only a limited amount that can be cut if there is hard times. The key is to have enough flexibility in the budget to accommodate most situations by avoiding long term contracts and large mortgage payments.

So how tight is your budget? Can you survive if you need to take a cut in pay? Note, the Excel spreadsheet on the prior page breaks Spending into the above categories (both by category of housing, automobile, loans, etc. and by "Must Haves," "Savings," and "Wants").

Exercise: Review your budget against the guidelines above, (e.g., house payment less than 28%). How do you stack up?

Exercise: Review your budget in terms of what would happen if there was a sudden loss of income or unexpected increases in other expenses. Do you have room in your budget to deal with these issues, or is the budget so tight there is no room for change?

If you do not have the flexibility in your budget, then you should start finding ways to become more flexible before it is too late. This may mean making some changes now and some changes when you are planning your next large purchase items (e.g., next car). Yet, it is better to make changes now before something happens where you are forced to change instantaneously (when it may be too late).

	Financial Topic : How to Succeed with your Budget
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