Ruly Challenge: Budgeting 101

Budgeting is one of the most basic financial planning methods but also one of the most powerful. A budget is nothing more than adding together your sources of income and subtracting your expenses. Your budget should be the baseline for all of your financial decisions. Most people, however, think budgeting is complicated, time consuming or have no idea where to start.

If you are only going to read one post at Ruly this month, this is the most important one.  Regardless of any other financial decision you make, if you structure your life so that you can comfortably pay all of your obligations as they come due each month, you should sleep well at night and hopefully amass wealth slowly over time.

Art Brown and Family on the couch. (1932) Photo by Theodor Horydczak. From the Library of Congress prints and photographs division.

Sometimes the best way to learn is by example. Allow me to introduce you to The Medians, our fictional family who loosely represents the data on median American income and expenses compiled by the Federal Reserve and the Census Bureau. Because the median doesn’t accurately capture any one particular circumstance, I have filled in a few holes based on my life experience to round out the Median’s finances.

The Medians are a Virginia family (husband, wife and two children).  They earn the American median family income of approximately $73,000.  Both Mr. and Mrs. Median are employed full-time.  Their children are cared for in a day care setting while their parents are at work.  Mr. and Mrs. Median commute to work in the Washington, D.C. metropolitan area.  Due to the high cost of living in D.C., they reside in the distant suburbs where housing is more affordable and commute long distances to work.  The Medians try hard to live within their means.  They aren’t extravagant in their expenses but they do indulge in a few treats: annual family vacations to the beach, visits to family during the holidays, cable TV, a restaurant meal out once a week and occasional wardrobe updates. Sometimes the Medians come up a little short each month and charge a few things to their credit card. They are still paying off car and student loans and their mortgage. They put aside a little for retirement savings each month in their 401(k) accounts and their employers match their contributions.

Peeking inside the Medians checkbook for the month, you see the following:

THE MEDIAN FAMILY BUDGET

ANNUAL INCOME

Mr. and Mrs. Median’s combined full-time salaries $73,000
Mr. and Mrs. Median’s combined 401(k)/retirement plan contributions $2,190
Estimated salary income after taxes and deductions for Social Security, Medicare, 401(k) and employer health insurance premiums $60,000
Estimated Monthly Disposable Income $5,000


MONTHLY EXPENSES

Housing
Mortgage Payment ($150,000 @ 5.5% interest) $851.68
Real Estate Taxes ($0.62 per $100 of assessed value on $200,000 home) $103.33
Home Insurance $24.75
Home Repairs/Improvements (1% of home’s value) $166.67
Subtotal Housing Cost $1,146.43
Food
Groceries (assumes the “Moderate” cost of food at home) $850.00
Restaurant Meals $120.00
Subtotal Food Costs $970.00
Transportation
Car Loan Payment $200.00
Car Insurance $166.67
Gasoline (assumes Mr. and Mrs. Median are driving to work) $400.00
Vehicle Registration/Inspection Fees $7.00
Car Tax (required in Virginia) $50.00
Car Repairs/Maintenance $100.00
Subtotal Transportation Cost $923.67
Child Care
Day care expenses and/or children’s classes/extracurricular activities $800.00
Subtotal Child Care Costs $800.00
Utilities
Electricity/Gas/Water $200.00
Telephone/Cell phone $70.00
Internet $40.00
Subtotal Utilities Costs $310.00
Debt Payments
Credit Card Payment ($3,000 balance) $150.00
Student Loan Payment $125.00
Subtotal Debt Costs $275.00
Luxuries
Clothes, shoes, haircuts, manicures, etc. $150.00
Gifts $50.00
Cable TV $60.00
Travel (cost of 1 or 2 big vacations per year, airfare, hotel, etc.) $125.00
Subtotal Luxuries $385.00
TOTAL ALL EXPENSES $4,810.10
MONTHLY NET INCOME $189.90

The Medians feel pretty good about themselves after this exercise. They have done a lot of things right. They are saving for retirement, they own a home and they are making regular payments on their loan obligations. And gee, they even have almost $200 left over at the end of the month. That’s pretty good, right?

Well…not really. While the Medians are doing a lot of things right, this budget is really pretty tight. The Medians spend every penny they generate. The budget prices only the average cost of expenses over the year. If the gas bill suddenly doubles in the winter, the Medians will have to charge that to their credit card, for example. The Medians also are not counting on the fact that since most employers pay every two weeks, their typical monthly income is more like $4615 with two months a year where it is $6923. So, 10 months out of the year, the Medians’ expenses put them in the hole by $200.

There are a couple of things that are not in this budget too that really should be, like life insurance on Mr. and Mrs. Median for the benefit of their children and a small amount for emergency savings. Mr. and Mrs. Median are not putting away nearly enough money for retirement and college savings is out of the question.

Any family budget with less than about $500 “fat” at the end of the month is prone to overspending in my experience. Even the most accurate budget is going to forget a few things. In the Medians case, for example, there is no allocation for charitable donations or religious tithing, which for many people is a common expense. Magazine subscriptions, impulse buys, computer upgrades, they all add up. Also, I have been a bit kind to the Medians on some of their expenses. For the DC area, their housing and child care expenses are probably on the low side.

Also, if you put this family under one extra bit of stress (higher taxes or health insurance premiums, Mr. Median gets laid off or Mrs. Median takes a 5% pay cut, one of the Median’s children has a medical emergency, etc.) this family’s debt load will spiral out of control. The Medians current situation assumes that everything in their lives will go perfectly. As we all know, this never happens. There always has to be some allocation for disasters.

Is it hopeless for the Medians? No. They can do a lot to improve their financial situation but they have to be realistic about how much things cost and consider adopting an extraordinarily frugal lifestyle for at least a little while to build up an emergency reserve. They might consider axing their “luxuries” for a while. Mr. or Mrs. Median could consider “slugging” to work to save on the transportation expenses. (Slugging is an unusual Virginia transportation solution wherein you drive to a commuter parking lot and hop in a car with total strangers so that the driver can take the fast highway commuting lanes (which require at least 3 occupants in the car)). They could stop eating out and try to adopt more frugal eating habits with their grocery shopping.

Is any of this fun? Not really. But this extreme frugality doesn’t have to last forever, just until Mr. and Mrs. Median pay off their credit card and build up at least a small emergency fund (say $5,000). The luxuries can work back in gradually, hopefully as Mr. and Mrs. Median’s income rises over time.

This type of exercise can be particularly stressful for those in retirement age or on fixed incomes. There could come a point at which the budget shows, for example, that a home is no longer affordable. Making a big change like selling a home is stressful and hard. Yet, we all have to be realistic that such a difficult change could come to any of us at any age. Rather than fear the change, I would rather be prepared to accept it.

Now that you have seen what life is like for the Medians, it is time to issue the Ruly Challenge.

The Challenge:  Create or update your household budget.  Have a firm understanding of your income and expenses.  Identify the costs that are fixed and the opportunities you have to save or improve your financial situation.

Below is a Ruly worksheet to guide you in your efforts. You have two options, the pencil and paper method or a spreadsheet with some calculations built in that can be adjusted over time.

Be brave!  This is the foundation of your financial planning.  There are no wrong or right answers.  Each budget should reflect the lives and goals of its planners.

Please feel free to share in the comments your thoughts on the Medians or budgeting in general. What advice would you give to the Medians?  (The Medians are fictional and don’t bear a grudge so if you have some tough love to give them, they can take it!) Do you think the Medians reflect the financial challenges of the typical American family?