There seem to be two schools of thought on budgeting. One suggests certain percentages of your monthly net income to allocate to certain categories: no matter how much you make, spend 30% on housing, 30% on life expenses, 10% on saving, etc. So, with a net income of $1000 monthly, you’d look for housing costing $300 and save $100; with a net income of $5000 monthly, you’d look for housing costing $1500 and save $500.
There are advantages to this, especially when you’re first wrapping your head around the idea of living within your means. For example, if you make $1000 a month but are spending $600 on housing, understanding that this is far too much, percentage-wise, might be the impetus to make a change. For me, the primary advantage is that thinking this way reminds me to keep my priorities balanced. I’m not especially good at financially multitasking; left entirely to my instincts I’d fling every last penny after a single goal and then move on to another, sequentially. That’s how I paid off my student loans (actually, that’s not how I paid off my student loans during the first seven months of debt repayment…more on that in a minute) and this strategy left me with $0 in my emergency savings and a cool $2000 in my retirement account at the end of my debt repayment period, so I’m not really sure I can recommend it. I’m trying to be a little less gung-ho, and limiting my retirement savings (current priority) to a certain percentage of my income is helpful.
But even though there are upsides to percentage-based budgeting, it has one fatal flaw, particularly for higher incomes: it builds lifestyle inflation right into the model. If I’ve increased my income to $5000 a month (I wish!) why should I suddenly need to spend $1500 on housing when I was doing just fine in the $750 apartment I lived in when I made $2500? Or even the $300 rented room I was in when I made $1000? If you need incentives to claw back spending in certain categories, percentage-based budgeting can help; if what you want to do is build your net worth, it’s really dangerous.
This year, I’ve become a big proponent of funding my priorities at the beginning of the budget period. Remember that seven months of student loan payments where I wasn’t “flinging every last penny”? I started out with about $19K. To pay it down in a year, and rounding up to account for interest, I should have allocated $1666/month, steadily. But in reality, I waited until the end of every month and then paid whatever was left over after all the other bills (rent, credit card, etc.) I did make progress, but not at the rate I needed to. Before I got to my end of the month loan payment, I first was paying for whatever else I’d done that month (clothes, groceries, gas, and anything else), instead of making the “anything else” come second, after I’d paid my loan. The end result was that in the last few months, I had to pay $2500 a month, which was a huge amount on my (then) $3800/month income.
What I used to do every month:
1) pay rent
2) spend money
3) pay bills, pay off my credit card
4) allocate leftover cash to loan payments
My big turnaround came when I realized if I wanted to do something, I had to do it first, before I started spending on “incidentals,” because those can get out of hand really fast. So now, at the beginning of the month, with a net income of $3150, I’m doing this, in order:
1) Retirement savings: $1000
2) Emergency fund: $500
3) Down payment fund: $125
4) Sinking funds for medical/repair/travel/other necessary spending: $550
5) Rent/Utilities: $425
6) Transportation (car insurance/gas): $100
7) Cash (covers groceries and most small purchases, like postage or coffee): $300
8) “Slush” (the fun money, for clothing, entertainment, charity, etc): $150
The order is really important.
What I did there was decide to allocate a certain sum to savings of various kinds — long term, medium, short term. I took those off the top. Then I added in the must-pays: rent, utilities, and transportation are relatively fixed costs, with a little wiggle room around gas. (Note how I did not assume that I needed to spend $945, which is 30% of my net, on housing; instead, I found the cheapest housing that I thought would be livable, which frees up hundreds of dollars that I’m putting in savings instead.) Only then did I get down to the more elastic categories. $300 in cash is way less than I would be spending on food, household items, postage, etc, if left to my own devices, but is generous enough to allow me to eat well as long as I’m careful. I also gave myself some fun money. So the “incidentals” are in there and I don’t feel guilty about spending that money, but it’s strictly limited by how much was left over after I set up my savings categories, instead of being in the driver’s seat.
This is working really well for me; it’s a comfortable point somewhere between percentage-based budgeting and the Frugalwoods’ excellent habit of just not spending money ever. (Which I greatly admire, but am not up to myself.)
Are there advantages to percentage-based budgeting that I’m missing? Is it obvious that I use YNAB now and love it?