When we ended the last post, your homework was to review your past 3-6 months of spending by breaking it down into categories. In this post, I’m going to provide some guidelines for what percentage of your income (net income for all categories but housing) you should be spending on each category. This will allow you to compare your spending to what is recommended and identify areas to improve. This is when a spending plan begins to come alive! But remember, your first spending plan won’t be a perfect one, but it will be a good starting point.
WHAT ARE THE OPTIMAL CATEGORICAL PERCENTAGES?
First, I’ll admit I don’t believe that anyone can say with 100% confidence that there are known, exact percentages. However, we do know that there are some well-established ranges in which people should keep their spending. One of the benefits of a spending plan is that you can decide to spend extra in one category if you are willing to decrease your spending in another. That is where the flexibility and individuality of a spending plan can work for you. We each have different priorities in our lives, whether it be pets, travel, skiing, etc. and we can make it work IF we plan for them.
See the excel file below for the recommended percentages for each category. My resources for the percentages are the Certified Financial Planner guidelines, Dave Ramsey’s Financial Peace University recommendations, Crown Financial budgeting recommendations, and other readings I’ve come across. Again, there’s no exact percentage for each category, but there are known ranges that spending beyond those ranges is known to place people at risk of living paycheck to paycheck. The key is developing a spending plan that works for your needs, wants, purchasing goals, and retirement goals with confidence.
WHAT OVERSPENDING IN SOME KEY CATEGORIES MEANS FOR YOUR FUTURE…
While every category of spending is important, there are two categories that deserve most of your attention because they have the biggest impact on whether you become financially independent or not: houses and cars. This isn’t to minimize the other categories, as they can definitely be a source of leaking out a lot of money that adds up. But, these other categories are much smaller, and as such will cost you thousands of dollars less over the course of your life than the decisions of what type of house to live in and what kind of car to drive.
Thomas Stanley, author of the The Millionaire Next Door and Stop Acting Rich… And Start Living Like a Real Millionaire has done decades worth of research on the blue-collar wealthy in America. (The blue-collar wealthy refers to a group of people he was initially surprised to find that makes up the majority of millionaires and wealthy people in America. They come from humble means and don’t live extravagantly, which is why he was surprised how many of them exist!) By examining this group of successful people and comparing them to similar people who failed to achieve a high net worth, he identified several areas in which the two groups of peoples’ spending was different. Cars and houses are the biggest and most important categories of your spending!
When we think about this a little more it makes sense. While some personal finance people talk about not buying expensive Starbucks coffees (not that they aren’t expensive!) to save $50 a month, Thomas Stanley says not to make 15-30 year-long bad decisions about buying or renting a home you can’t afford. Basically, he says do the big things right and that will have a huge, positive impact in your financial situation. What bigger purchases do we make in our life than a house? I can’t think of too many things more expensive than a house. And, when we think about cars, how many cars will we own in our lifetime? When we add up all the expenses, and especially the interest we pay to make these big purchases, we see how compounding interest works against us! Instead of having our money compound for us, we send it to a financial institution (bank, dealership, mortgage company, etc.) that uses our money to compound for them! This is the opposite of financial wisdom!
The reason we fall into these traps of buying houses and cars that we can’t afford comes down to a couple reasons. First, it’s been said that our current generation, that I myself fall into, want RIGHT NOW what took our parents’ and grandparents’ generations 30 years to achieve! We want the nice, big house and two new cars when we get married. We don’t want to patiently work our way up to a bigger, newer house and newer, nicer cars as our careers progress and paychecks go up, we want them now! The irony of these decisions is that we end up living in and driving our future retirement dollars down the road and end up with less money at the time in our lives when we need it the most!
In future posts, I’ll break down how much money, and it’s in the thousands to nearly hundreds of thousands, of dollars that your family can save by living in a slightly smaller and older, but still very nice home and driving cars that you purchase when they’re 3-4 years old instead of brand new. It’s mind-blowing when you see this money add up! Then, you’ll realize why it seems like you can’t get ahead, and there’s never money left after paying all your bills for retirement investing. This is why the average, middle-class American struggles so much to make saving and retirement a reality. For some, there’s going to be the realization that you might need to sell something to downsize. This is where personal finance isn’t fun because we lose some of the very things we grow to love – even though they’re just that – things! But, I would suggest that if you don’t make a change in your spending you should plan on continued financial stress instead of independence. There’s good research that shows that the happiest people aren’t those that don’t have the newest stuff and cars, but are those that have less financial stress and aren’t out to impress other people!
With everything we just discussed in mind, briefly consider some of these findings from Stop Acting Rich… And Start Living Like a Real Millionaire. Three times more millionaires live in houses valued at less than $300,000 than live in homes valued at over $1,000,000!!! And yet, I know a lot of people whom I know are not millionaires that live in houses costing way over $300,000! Can they afford it? Probably not. Another area of financial literacy is the false belief that property goes up more than the stock market. When we start talking about investing, we’ll compare stock market returns to real estate returns and see that this isn’t true. However, for today, suffice it to say that the house you live in is your home – a home is not an investment because you cannot sell it to pay your bills! The house you live in is considered a Use Asset. This means that while it is worth money, it’s not purely an investment because if you were to sell it you would have to use that money to pay for a new place to live. (hopefully you would have some equity in your home, but it won’t be the full value of the house) You’ll basically have just shifted your situation around, not solved it. Now, if you own a rental property, that IS an investment so long as you have a reliable tenant, but this is much different than viewing the house your family lives in as an investment, though it is an asset.
The average millionaire also drives a Toyota that is 2-3 years old when they buy it. The average price that millionaires spend on a new car, for the ones that do, spend around $30,000 on that new car and 50% of millionaires spend less than $24,800 on a car! Now think about this stat – 86% of “luxury” cars bought in America are bought by non-millionaires! I know so many people that drive more expensive cars than $25,000 to $30,000 and I also know they are not millionaires. They’re making huge monthly payments that they can “afford” – they think. But the truth is, we the middle class cannot afford it. We buy luxury cars to look rich while our truly rich neighbor, the blue-collar millionaire, drives a Toyota! These are choices we have to take seriously if we’re going to improve our financial situation. We’ll talk more about cars in the future.
There is certainly over-spending that occurs in other categories such as food, clothing, education, vacation, or whatever it is for you, but remember that thee categories are relatively cheap in comparison to a home or a car. Now, this isn’t an excuse for you to pass by that because these can easily add up to break you. But, this is more of what I want you to focus on AFTER you examine what percentage of your income you’re spending on your house (rent or own) and your car. Then you can look closely at these and find some more room for improvement.
SOME OTHER BASIC GUIDELINES FOR DEBT AND SAVINGS
When trying to figure out how you’re doing, use these percentages as guidelines. These are well-established to determine if people are overspending in some big areas or not.
- Monthly consumer debt payments (credit card balances, personal loans, etc.) should be LESS THAN 20% of your net monthly income (remember, net income is the after-tax amount that gets deposited into your bank)
- Housing costs (principle, interest, taxes, insurance, and homeowner’s association fees, AKA “PITI”) should be LESS THAN 28% of your gross monthly income (here, we’re using gross income, so the pre-tax amount of your monthly pay)
- Now, on the spreadsheet, I lumped utilities and housing together because they’re mostly fixed expenses each month so that’s why that percentage is adjusted up a bit to around 35% of your monthly pay
- Total monthly payments for ALL debt (housing, credit cards, car loans, other loans, everything) should be LESS THAN 36% of your gross monthly income. If your debt payments are over 36% of your gross monthly income then this indicates you are overspending on multiple categories. Remember, just because you can “afford the payment” doesn’t mean you can afford the purchase! This is also a good indication your money is compounding interest – for the other person/business!
Finally, now that you have some general principles for how you are doing with your debt, let’s look at one that can give you an idea of how we’ll you’re doing with your saving and investing.
According to Fidelity Investments (which is an excellent online investment service) your goal should be to have 10X your annual salary in investments by the age of 67. I know other financial bloggers/experts that recommend having much more than this, up to 25-40X!! This high extreme is more practical for highly affluent people with large paychecks (doctors, lawyers, CEOs, some business owners, etc.) but the smaller number, 10X your annual income, is realistic for the average middle-class American – even if it doesn’t seem like it today!
Here’s the age-related bench marks to compare yourself to at whatever age you currently are:
- Age 30 = 1x your salary in savings/investments
- Age 35 = 2x your salary in savings/investments
- Age 40 = 3x your salary in savings/investments
- Age 45 = 4x your salary in savings/investments
- Age 50 = 6x your salary in savings/investments
- Age 55 = 7x your salary in savings/investments
- Age 60 = 8x your salary in savings/investments
- Age 67 = 10x your salary in savings/investments
Now, this may seem impossible, but there are plenty of people in middle-class America that are achieving this! Starting ASAP with saving and investing will turn this possibility into a reality! It is definitely harder for you if you are already later into your life/career and have less years to save. Here are the 3 most important investing principles that make this possible:
- Time in the Market: Start investing for your future as early as you can in life. Even if you’re 23 and it’s your first job and you don’t have that much to save, save it anyway! Start the habit of paying yourself first and as your salary goes up over time you’ll save more and more! More years in the market means you’ll get more compounding interest and dividends out of your money than if you wait until later in life to begin investing!
- Asset Allocation: This usually refers to your mix of stocks/bonds, but also refers to some other investing decisions such as domestic/international stock, large cap/small cap, etc. asset allocation decisions. We’ll cover this in detail in the future, but for today, just know that you will not achieve financial independence if you put all your savings in a bank savings account. The interest rate in savings accounts simply don’t pay a meaningful return. You need to be invested in the stock market. For right now, a simple S&P 500 fund or a Total Stock Market Index Fund is sufficient. (I use Vanguard, so the Vanguard 500 Index Fund Investor Shares (VFINX) or the Vanguard Total Stock Market Index Fund Admiral Shares(VTSAX) is a great starting place and you can add to it as you learn more.) But you have to be invested in the stock market, otherwise you won’t achieve your long-term financial and retirement goals.
- Aggressive Saving Rate: Typically, it’s recommended that people save 10% of their income for retirement. I would suggest that 10% isn’t enough anymore. Some reasons for this are: 1) We don’t save as early in life as people used to, 2) everything is becoming more expensive, and 3) we’re living longer on average and our retirement funds need to last longer as well! So, my recommendation is to aim for a minimum of 10% and work towards 15% to 20% savings rate automatically invested each month into a work sponsored 401k (take FULL advantage of their match, that counts towards your 15%!) and/or a Roth/Traditional IRA (for now, we’ll say a Roth is the best option, we’ll talk about why in a future post). An aggressive savings rate is one way to worry less about your investment returns as it can compensate for lower, more conservative investment returns and you’ll still come out really well!
To save aggressively, you must stop going into debt, pay off your debts, and re-prioritize where your money is going rather than having to work in your retirement years.
WHAT TO DO
The main reason why these percentages are important is because they are your guide to financial success. If you don’t know where your money is going, you don’t know where to cut back or how to save more. Tracking your past 3-6 months of spending and beginning to actively track the next 3 months of spending will give you a frame of reference from which to begin modifying your spending. Everything seems like a need until you start tracking it. So, use what you put together last week and copy it into this spreadsheet. You’ll get the percentages automatically to show you how you’re doing.
As you’ll notice on the spreadsheet, there’s not a recommended spending allocation for pets. But, the money must come from somewhere (I recommend allocating ~3-5%) so you’ll have to decrease another category so that your percentages add up to 100%.
FYI, the categories on the excel spreadsheet have ranges that are considered appropriate spending ranges, but remember that for your own percentages they will add up to 100%.
Remember, these category percentages are a strong guideline to tell you where you’re over or under-spending. So, fill in your information onto the excel spreadsheet (copy and paste it in for the number of months you tracked) and I have the formulas set to automatically calculate your percentage of income spent on each category.
- Look up your net monthly income for the past 6 months. This is usually much easier than tracking your spending because most people only have 1-2 sources of income. Fill in the data on the spreadsheet and you’ll get your average monthly income.
- Copy and paste your 3-6 months of spending tracking into the spreadsheet cells that match the prior spreadsheet I posted. I have the formulas set to automatically calculate your percentage of net income that you spend on each category. (**I have the formulas set to calculate 6 months’ worth of data – if you only tracked 3 months, then only put in 3 months’ worth of data and click in the cells on the right that have “Average…” at the top of the column and change the “6” to a “3” in the typing bar at the top of the spreadsheet or whatever number of months you tracked and hit “enter” and it will update. Then you should be able to copy and paste that updated formula into the other cells in the same column.
- How do your percentages compare to the guidelines? Which categories are you over-spending in or under-spending?
- I’m a believer in getting quick wins (easy, small changes that can have big results asap). What categories can you get some quick wins by modifying your spending to increase your savings?
I’ll leave you with a quote I’ve already left you with, because it’s so good you need to see it over, and over, and over until it’s memorized and ingrained if your head!
“A budget is people telling their money where to go instead of wondering where it went.” – John Maxwell
Best of luck this week,