Setting a Budget and Living Within Your Means
Last week, we provided insight into the importance of checking your credit report once per year. On a parallel path to working through inaccuracies or negative information on your credit report, your next step is to establish a budget that will help you get ahead. Though many Americans live paycheck to paycheck, this can be dangerous territory. It is simply not a sustainable process. And, if something goes wrong such as you incur an unanticipated medical expense, you experience a job loss, or other, you can quickly find yourself in a position where staying on top of your bills is no longer possible.
When you get behind in your bills, you risk a negative impact to your credit score. And though many choose to take out Spotloans or come up with other financial resources to ensure payments aren’t missed (and thus reported to a credit bureau), this can become a very expensive endeavor.
Indicators That You Are Living Outside Your Financial Means
Living paycheck to paycheck is not uncommon for today's Americans. However, it can cause challenges for those who may need to take on additional debts. If this feels like you and you also resemble one of the following indicators, it is time to put some financial recovery plans into motion.
- Your credit score has fallen below 600. According to FICO, a good credit score is something above 670. And, most credit scores fall between 600 and 750. So if you are below 600, this is a huge red flag that some changes are in order.
- You are saving less than 5% of your net income. As you will see from the recommended budget system that we will share in a bit, if you aren’t saving, or are saving less than 5%, you are putting your financial future, and retirement, at serious risk.
- Your credit card balances are rising instead of falling. With your credit cards, any time you carry a balance, you accrue interest (unless you have a special promotional offer, and in that case, it won’t last forever). So, with every month that you carry over a balance, you spend more and more money that you will never get back. Further, if those credit card balances are increasing, it will create a dip in your credit score as creditors want to see that you are paying down your balances.
- You are putting more than 28 - 30% of your gross income towards housing expenses. As you will learn shortly, it is suggested that you spend only 50% of your net income on need-related expenses, and housing is a big part of that. If you are spending more, this is yet another red flag that you need to make some changes.
- You are finding it harder and harder to pay your bills. Though it is not expected that you will always have the cash on hand to pay a bill the moment it arrives in your email or mailbox, your goal should be to make this more of a norm. If you are shuffling through bills each payday to see which ones you actually can pay, this is another sign of trouble.
Developing a 50/20/30 Budgeting System
Thus, if you are in a situation where you are living paycheck to paycheck or you are getting further and further behind every month, it is time to reassess. It isn’t always possible to earn more money and so it is important to be smarter with the money you have. To ensure that you don’t get into a financial situation that you can’t get out of, it is likely time to apply a 50/20/30 budgeting approach. In its simplest approach, this budgeting system takes your after-tax income and allocates it as follows:
- Spend 50% on your needs
- Spend 30% on your wants
- Invest or save the remaining 20%
Your needs include those items such as mortgage or rent, car payments, insurance, health care, groceries, utilities, and debt payments. And if you are doing it right, make sure that your needs don’t include things like eating out or your Netflix subscription (those should go in the wants category).
On the flip side, your wants should include expenses related to going out or eating out, subscription-based items, new gadgets, vacations and holidays, etc. This budget category is all about the fun things that you want to spend your money on, to make life more enjoyable.
Finally, the remaining 20% should be invested in the future. This might mean that the money gets socked away in a savings account or rainy day fund. Or, perhaps you will want to contribute money towards a Roth IRA to help with your retirement. Wherever you choose to place these funds, the goal is to set yourself up for a financially sound future. This said, if you are new to adopting the 50/20/30 budgeting approach, you may want to consider your current debt situation. If your credit card and other debts have started to get out of control, you may want to adjust your 20% to 10% for the next 12 months, and take that remaining 10% to help eat away at that debt. Not only will this help you live within your means in the future, but it will also help you to improve your credit score.
