|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
The Dollar Stretcher website
http://www.stretcher.com. You'll find hundreds of FREE
articles to stretch your day and your budget!
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'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
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
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
OK, so let's look at one possible
budget for Debbie. This one uses after-tax income.
& Life Insurance
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.