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Why a spending plan pie is important for budgeting


Preparing a budget is an important step in becoming financially fit. If you just prepare a budget based on what you are currently spending, you might not really be helping yourself all that much.  Your current spending habits in certain areas may be more than what is optimal to gain financial freedom.  What you really need to do is allocate your monthly income using a budget pie assigning percentages to the important categories.
 
Why is a budget based on our current spending habits not really that helpful?
That type of budgeting tells you where you are spending your money but it doesn’t really tell you where you are spending too much money and that’s the key to financial freedom.  If we create a spending pie, and compare it to our actual expenses, we can then learn where we need to improve. The key to budgeting is not tracking where you spend your money but rather how you spend your money.
 
How many different categories should one have in their budget pie?
Seven to ten are ideal depending upon how detailed one wants to become in allocating their income.  More than 10 and it is really hard for it to be useful and if you have less than 6 you often can mask bad spending habits in some of the more important spending categories that are truly discretionary. The key is finding the categories that make sense for your current situation.
 
What would be some of the suggested categories for a budget pie?
Housing (20%), transportation (10%), food (12%), entertainment (4%), short term savings (4%), retirement savings (10%), utilities (6%), insurance (7%), taxes (16%) and a catch all category (11%) of other stuff would be a good set of categories to use for an effecting spending plan.  This is based on gross monthly income using an annual household income of $60,000, so the tax rate will be different at different income levels and the percentage for each category will be adjusted accordingly.
 
Are there any suggested percentages that might different than conventional wisdom?
Probably the biggest would be in housing, if you can keep this to less than 20% of your gross monthly income you will see a big impact on the funds you have for other slices of the pie.  This is lower than what a lender will qualify you for with a mortgage but this keeps you from being house poor.
 
What are two categories that are often out of control?
The two biggest are entertainment which should be around 4%  and is often  twice that amount and the other stuff category which includes gifts, clothes, vacations which should be around 11% and is often closer to 20% which means that people use credit card debt to fund these expenses.
 
What about student loans or credit card debt in your categories?
All debt besides auto loan and housing debt need to be funded by reducing all but two of your major slices of the budget pie to make your credit card or student loan debt payments.  Don’t start with an allocation for those categories, you really need to setup your major categories and then decide where you are going to find the funds for student loans and credit card debt.  For example, you might need to make your housing only 15% so that you can use the remaining 5% for student loans or credit card debt.
 
What two should not ever be reduced?
The short term savings slice which should be around 4% and the retirement savings which should be around 10% should not be reduced if at all possible.  And if you plan to save for college, make sure to take those funds from another category besides retirement or short term savings too.


Posted: 6/4/2015 with 0 comments

Categories: Budgeting, Money Matters, Spending



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