Congratulations you have officially graduated from college, let's drink, party and celebrate! Just kidding, I'm not sure what all the celebration is about, because after 4 years of college, you more than likely have never taken a personal finance course. Even if you were a finance and accounting major like me, you likely have never taken a personal finance course. And if you're one of 44 million Americans, you've officially been given the responsibility of paying back tens of thousands or even hundreds of thousands of dollars in student debt! We will tackle the challenges and solutions of student loans in a later post, but for now, let's focus on creating a budget and sticking it to. Creating and sticking to a budget early on is crucial to your future success as you are building the core values for your future. In my opinion, the most essential value is being disciplined. Being disciplined will not only allow you to stay on budget but will enable you to begin growing your money and begin building real wealth. But don’t worry, this post is designed to show you how to create a substantial budget, and how to optimize that budget to fit your lifestyle. Okay enough small talk, let's dive in.
The 50/30/20 Rule: This is a relatively simple budget we can all follow. It breaks down your income into three distinct categories; your needs, wants, and savings. Let's say for example you earn $50,000 a year after taxes or $4,166.67 per month. Let's break this budget down.
Your Needs (50%): $2,083.33 should be spent on items such as your mortgage/rent, student loans, credit cards, utilities, groceries, cable, phone, transportation, and healthcare, just to name a few. The good thing about this component of your budget, is most of these items are the same or similar every month so we can better predict future months. Napkin Note: As a general rule of thumb, let's try to keep your mortgage/rent expense under 35% of your total after-tax income. Those who do not follow this rule will find it difficult to fulfill the "Your Wants" section of your budget, which is basically where all the fun is. But don’t worry, it‘s fairly easy for you to spend less than 35% of your income on rent. In my budget below, I have been able to spend just 26% of my after-tax income on rent.
Your Wants (30%): $1,250.00 can be spent on travel, clothing, parties, eating out/bars, and or anything above the "your needs" component. Basically, this section is all about you, and making you happy. So please spend it however and on whatever you want. If it is not a necessity, then it will more than likely fall into this category.
Your Savings (20%): $833.33 should be placed into your savings account until you have at least 6 months or $16,250 as an emergency fund. I arrived at this number since it is 6 months of "your needs" and 50% of "your wants." Some people might argue a 6-month emergency fund is too large, versus a 3-month fund. At the end of the day, the decision is up to you, but I feel a lot more comfortable with knowing I have 6 months of expenses secured then just 3 months. And the good news is you will be able to build a 6-month fund after 20 months of savings.
Having an emergency fund is critical, and most people do not follow this step, but having one will provide you with comfort, should you become unemployed, have health bills or just spent way too much one month by accident. Please remember your emergency fund should never be used for "your wants." Should you want to go on a $1,500 fancy vacation, then you will need to lower "your wants" and increase "your savings" until you have $1,500 above your emergency fund. But remember you can and should budget for a vacation in the "your wants" section of your budget as I did in the budget I created below. Once you have established your emergency fund, we will discuss what you should do with the additional savings in a future post.
You may have noticed I have not mentioned anything about your 401-K contribution. That is because this is a pre-tax item. Meaning contributions are taken from your paycheck before taxes are deducted. Once you become employed, generally after 90 days if your company has a 401-K program, 3% per paycheck will be automatically deducted from your pre-tax earnings and placed into your 401-K. Unfortunately, 3% is not enough, and you need to try to contribute at least 8% - 12%, and please strive for 12% at a minimum. Under IRS rules, we are allowed to contribute $18,500 per year of pre-tax income, which does not include any monies your company matches. I will review this benefit and more on 401-K and IRA accounts in a later post, but for now, just keep this in mind.
I want you to know I understand the 50/30/20 budget may be challenging, especially for those of us with loans and other obligations, but sacrifices must be made for your future. I completely understood those who want to live in the now and enjoy life today, and my mission is for you to be able to achieve that. But it would be irresponsible for me to tell you what you want and not be realistic. Saving and investing for your future will secure your future financial independence at a much younger age then you think if you are consistent and disciplined.
The 50/30/20 rule can and should be customized to meet your needs, but please do not lower the 20% savings level. This was a pretty broad overview of the 50/30/20 rule, so now I want you to be able to dig in deeper, and learn about all your expenses. I have created a generic budget based on a person's after-tax income of $50,000 in a high tax state and city like New York, NY. Please use this as a guide as you begin to create your own budget. You may look at this and be completely overwhelmed, but please review it line by line and it will start to make sense to you. If you have any questions or comments, please write them in the comments section below.
Budget Optimization: Now that we understand how to create a budget, we need to learn how to optimize it. As soon as the first month is complete, I would like you to create another budget template like the one above, but this time use exact numbers based on what you actually spent each month. You will then clearly be able to see if you stayed on, under or over budget, and specifically in what category. For example, I have allocated $250 per month in my budget for restaurants, but lets so I actually spent $350. I now have a mental note in my head to either decrease spending on restaurants in month two or increase my budget to $350, and decrease other items in my budget by $100. After a few months, you will have crafted a unique budget that fits your needs.
As I hope you are beginning to understand, none of this is rocket science and should be reasonably simple for us once we know our budgets. Then why doesn't everyone create a budget, you might ask? I believe the answer is something I mentioned before, discipline. Some people think this takes too much time and work, and they can better manage their own budgets in their head, using the "in my head" method. This is equivalent to a pilot flying a plane from New York to Paris only using a compass. Yea, the pilot, might make it, but he won't take the most efficient route, saving the airline time, wear and tear on the aircraft and most importantly money. We only earn so much money. And we must be able to use each dollar as efficiently and effectively as possible. In my opinion, creating a budget and tracking your spending habits will help achieve this. My primary objective is to help you succeed and grow. So please leave comments and questions below, so I can better answer your specific questions and concerns.