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I understand that 25% of my monthly income should be for mortgage, taxes
and insurance. How much should I plan for the remainder of my budget? There
are two of us in our household. Is there a set formula? Also, if I plan to
retire in the next 5 years, should I be carrying a mortgage for the sake of
a tax write off?
Debbie
Debbie's first question is a very good one. Knowing how much you can afford
to spend in any category is important to a successful financial plan.
There is no set formula for dividing up a budget. That's because every
family is unique. Housing costs vary by region. Family size and age will
effect expenses. So your best plan is to adjust your budget until you find
a formula that works for you. And, even then, you'll need to adjust it
occasionally as your family circumstances change.
A budget shouldn't be a straitjacket. The best use is as a guideline for
your expenses and an early warning sign of trouble ahead. A budget can do a
great job of telling you where a problem is and can even help you find a
solution.
The trick is to keep the total spending to less than 100% of your after-tax
income. You can spend more than you make if you use credit cards to borrow
money. But doing that makes it harder to live within your income the next
month. That's because you've accumulated debt that will need to be paid
back with interest.
The two most common causes for budget failure are housing and automobiles.
Both problems are hard to correct. You can't sell a little bit of your home
or car. And it's very difficult to save enough in other areas to overcome a
big ticket mistake.
When you prepare your budget you'll probably have a hard time deciding
where to put certain expenses. For instance, dinner with friends could be
considered food. Or it could be entertainment. Where you put it is not
critical. But, making sure that you don't overspend both food and
entertainment is important.
OK, so let's look at one possible budget for Debbie. This one uses
after-tax income.
- Housing - 30%
- Auto - 15%
- Food - 17%
- Health & Life Insurance - 5%
- Entertainment - 7%
- Clothing - 4%
- Medical - 6%
- Debt Repayment - 5%
- Savings/Investment - 5%
- Misc. - 6%
How does it work practically? For illustration, let's assume a family
income of $60,000 per year after taxes. That may seem like a lot. But,
you'd be surprised how quickly you can spend $5,000 per month.
If Debbie spent 30% of her income on housing, she'd have $1,500 per month
to work with. That would include her mortgage payment, taxes, insurance,
maintenance and repairs. Many are tempted to buy a more expensive home.
There are even some professionals who advise clients that they'll do fine
committing 35% to housing. Often the result is a family struggling with
mortgage payments that are too big. And finding an extra 5% in the other
categories is often painful.
On the other hand, let's suppose that Debbie manages to keep her household
expenses to 25% of her income. That will allow her an extra 5% to use in
other places. That $250 each month could be used to repay debts, save for
retirement or spend however Debbie wanted.
A word about automobiles. Trying to fit two car payments into our sample
budget could be difficult. Debbie would have $750 per month to spend.
Besides any car payments she needs to leave some money for insurance,
registration, gasoline, tolls, maintenance or repairs. Realistically to
keep two cars on the road, she'll probably spend about $150 to $200 per
month above her payments. So Debbie really only has about $550 per month
that can go towards car payments.
Note that the 'debt repayment' category does not mean making minimum credit
card payments. It means repaying previously accumulated debts. You should
always plan on paying off any new charges completely in the month that they
occur. Ideally, Debbie wouldn't have debts to repay and could allocate 10%
for retirement savings.
Debbie's second question is easier. No one should be carrying a mortgage
for the tax deduction. It's really pretty simple when you cut through the
jargon. You borrow money and pay interest on the loan. For every $1 in
interest you pay the mortgage company, at tax time you'll deduct $1 from
your income. Depending on your tax rate you'll save 15 to 30 cents. Trading
30 cents for a dollar is not a good idea!
Some would argue that the money that you don't use to pay your mortgage can
be invested to earn more than the mortgage costs you. But you'll need a
return that's guaranteed as to principal and earnings for an apples to
apples comparison. And with very rare exceptions, you won't find it. For
instance, if Debbie has a 5% mortgage and is in the 30% tax bracket the
money will cost her 3.5% after taxes. She'd need to find a guaranteed
investment that would pay that much after taxes.
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