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This is an article in an occasional series on personal finance. Each article will address a different aspect of personal finances and provide some tips for you. However, always consult your own financial adviser or tax professional for your specific situation.
One of the more common pieces of financial advice for new college graduates is to set a budget to be smart with their money. Chances are, this is the first time the new graduate is handling real money while making major life decisions.
Just for budgeting, there are a number of different methods and each one can be effective. Before deciding on which method would be best, there are some basic guidelines to keep in mind to be financially sound.
First, housing costs – whether rent or mortgage payment – should be around 25 percent of gross monthly income. That is, if you make $1,000 per month, your rent or mortgage payment should be no more than $250. Including utilities and homeowner’s or renter’s insurance, that figure could be in the 30 – 35 percent range
(Yes, mortgage lenders will go to a higher debt to income ratios. In fact,there are some programs that will go as high as 50 percent debt to income ratio. Is it any surprise, then, that the average American family lives pay check to pay check, and couldn’t handle an emergency $400 expense without going into debt further? [Source – Federal Reserve Bank – Survey of Household Economics and Decision Making]
After housing, total debt payments, whether credit cards, auto loans, or student debt, should be no more than 10 – 15 percent of gross monthly income.
Taken together, housing and debt should be under 35-40 percent of gross monthly income.
With those in mind, there are several ways to create and follow a budget.
First, a common way to budget is using an app. There are many apps available, and often these will connect to your bank accounts to provide an integrated picture of your cash and expenses.
One advantage of using apps is simplicity. No more keeping and entering receipts. No more worrying about categorizing expenses. And it’s automatic. Make a purchase using your debit card, for example. The transaction hits your bank account, which is then picked up by the app.
The downside? It’s a little too easy. There are apps that will offer tips and warning notifications whenever you exceed certain limits. But these apps don’t stop you from exceeding those limits anyway.
A second way is the “two account” system. Using two separate checking accounts, one account would be used for fixed expenses only, such as rent/mortgage, loan payments, and cell phone – the expenses that truly don’t change month to month. The second account would be used for everything else.
Add up all of the fixed monthly expenses and then divide by the number of pay checks per month. For example, if fixed expenses are $1,000 per month, and you get paid twice per month, then $500 from each check would go into the fixed expense account. You could easily set this up via direct deposit from your pay check.
The advantage of this arrangement is that this clearly shows what is fixed versus discretionary. And of course, since the second account is for everything else, you don’t really need to budget by category (e.g. food, gas, etc.). As long as you don’t spend more than what’s in the account, you’re fine.!
There are a few downsides. One is an issue of timing. When you first set up this system, you may not have enough money in the fixed expenses account to cover the bills due until you get paid. For example, having bills due on the 10th of the month, but not getting paid until the 15th. So, you’ll need some amount of cash to avoid this problem by creating a “timing buffer.”
The other downside is that if the two checking accounts are connected, there will be times when the fixed expenses account will have a large balance, which may tempt you to transfer money to the everything else account to spend. But that large balance is only temporary since the money is already set to pay upcoming bills.
The third way is probably the most effective, yet old school way. It’s the envelope/jars method. Very simply, you set up envelopes or jars with each one for a specific purpose such as groceries. When you get paid, get your pay check in cash and put money into each of the envelopes. That way, you can very clearly see how much you have – or don’t have.
And that is the major advantage. This is the most real and clear system because you literally can see how much cash you have left. That has a major psychological effect and really forces discipline. If you’re out of money in one category and want to take from another, you have to actually take from one envelope to move it to another.
The downside is that you have a bunch of cash around the house, and you have to remember to bring your envelope/jar with you when you go out grocery shopping, for example. And you would really have to resist the urge to pull out that credit or debit card that we’re all so used to.
Which one is right for you? There’s no clear answer. It depends on how you handle money today. If you are pretty careful with money now, perhaps the app would be the best. Alternatively, if money burns a hole in your pocket, maybe the envelope system would work best for you because it really forces discipline.
Ultimately, whatever you decide, getting a handle on your budget and finances today will avoid a lot of stress later. And that is some of the best advice I can give.